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FIN 200 Assignment

Student’s Name

Institution
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The Security Market Line (SML)

The Security Market Line visualizes the Capital Asset Pricing Model (CAPM) ,

showing different degrees of systemic or market risk in specific marketable securities plotted aga

inst the expected return rate of the overall market. Often, SML is referred to as a visualization of

the capital asset pricing model (CAPM), where the graph's x-axis indicates a securities risk with

beta value and the graph's y-axis is expected rate of return (Fabozzi, 2016). A provided security's

market risk premium is calculated by checking where it is plotted concerning the SML on the

graph. In principle, the SML can be plotted using the risk-free rate and beta (market return –

risk-free rate). The formula that is used in plotting the SML, therefore, the CAPM model which

shows the following:

Required Return Rate = Risk -Free Rate + Beta (Market Return – Risk-Free Rate)

SML is a critical tool for investors when evaluating a specific security in a portfolio. Usually,

investors would be interested in determining whether particular security offers an attractive

return with respect to the risk that the security exposes to the investor who holds it.

SML Graph
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If we examine the SML graph, the point where beta is equal to zero is the y-intercept.

SML is similar to the idea of a risk-free rate at this stage. Besides, the slope of the SML reflects

the risk/return trade-off at one point in time and is equal to the risk premium provision (Fabozzi,

2016). The graph’s slope is such that as the systematic risk increases, investors should be

compensated with a higher return. If a stock is plotted on the SML chart, it is considered

undervalued if it appears above the SML graph, because the position on the diagram indicates

that the security offers a more significant return against its inherent risk.

On the other hand, if the security plots below the SML, it is considered to be overvalued as the

expected return does not cover the risk inherent. Such stocks are represented by dots that are

either plotted above or below the SML respectively. A beta value of 1 is perceived to be the

overall average of the market, as indicated on the graph. Further, a beta value above one

represents a degree of risk higher than the market average, whereas a beta value below one

represents a degree of risk lower than the market’s average.

The SML line is, therefore, useful in measuring two key concepts of security. These

include a security’s inherent risk (which cannot be diversified) and the corresponding return rate

that is enough to compensate an investor for holding such security. Investors are only concerned

about determining if an investment is overvalued or undervalued. As seen from the description,

the SML (Fabozzi, 2016) is used as a benchmark to show over/undervaluation of a particular

security. Once a rational investor has determined the securities which are currently overvalued or

undervalued, he or she will avoid the undervalued securities in a portfolio and include the

undervalued securities in a portfolio.

Capital Market Line (CML)

The Capital Market Line (CML) is a graphical visualization of the C, which sows the

CAPM, which combines risk and returns to the optimum level. CML graphs all portfolios that

blend the risk-free rate optimally with the risky asset market portfolio. A key feature of the

capital-market analysis is that the story contains non-risk investments. As such portfolios that are

plotted along the CML have no risk, hence referred to as efficient portfolios. The capital-market

line concept is useful in determining a portfolio's results. Because it brings up the concept of

risk-free assets, explaining how such assets are distributed is important. Therefore the capital

allocation section allocates risk-free assets and volatile investments for the investor. As earlier,

pointed on the critical feature of the CML, risk-free assets are included, a concept that

distinguishes the CML with the more popular efficient frontier (Heck, 2013).

Concerning the risk-free premium concept, there is also the equity mix, which is fully

diversified and only embedded in the systemic risk. In such a scenario, the expected return will

be equal to the gain on the business. The formula leading to CML is as follows:

E(RM) - RF
E(Rx) = RF + SDx 
SDm
Where SDx is the standard portfolio X performance

deviation; SDm is the default deviation to market return.

Graphical representation of CML

All the points mapped along the CML reflect portfolios with better returns relative to any

portfolio plotted on the efficient frontier, exclusive to the stock portfolio where the CML is

tangent to the efficient market frontier. Point M is the CML tangency map and the efficient

frontier, as seen from the line. Therefore, M is made up entirely of a risky asset and is not a risk-

free asset. Points located westward and above the CML are unfeasible. Conversely, points

situated to the right and below are possible yet unsuccessful. The CML gradient is the company

portfolio's Sharpe ratio.

A prudent investor should sell any stocks that are below the CML's Sharpe ratio and

purchase those that have  a Sharpe ratio above the CML. It is impossible to beat the competition

according to the efficient market theory proposition. As such, both investments are supposed to

have a Sharpe ratio equal to or less than the markets (Heck, 2013). Therefore, the CML graph

reflects the expected return rate and a portfolio's standard deviation which lets investors visualize

productive portfolios. In this scenario, the efficient strategies subject the investor to a minimum

risk for a certain return price.

The difference between CML and SML

a) Risk assessment
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Security market Line measures the degree of risk with a beta application for a particular safety.

By contrast, using the standard deviation, the Capital Market Line (CML) measures the risk of a

portfolio.

b) Portfolio vs. Stock

Capital market Line assists investors in determining the risk or the return for efficient

portfolios. For example, the y-axis of the CML represents the expected return of the portfolio

and in general, the SML determines the risk or the return of an individual stock. Efficient and

non-efficient

The Capital Market Line offers an overview of efficient portfolios only. On the contrary, the

Security Market Line helps investors to visualize both efficient and non-efficient portfolios.

Minimum Variance Portfolio (MVP

Investment opportunities are described using two key components which are interrelated.

The components are risk and return (Heck, 2013). For a given level of return, rational investors

are interested in achieving the minimum possible risk. The modern portfolio theory emphasizes

minimizing the risk exposure of particular security while maintaining a constant level of returns.

This is referred to as the diversification of securities in a portfolio. The key focus of

diversification is to ensure that if an investor has invested in two securities, an increase in the

price of one security does not increase the price of the other security by the same level and vice

versa. Diversification under the modern portfolio theory, therefore, brings us to the idea of a

minimum variance portfolio.

The minimum variance portfolio is defined as a portfolio that combines securities

intending to reduce the price volatility within the entire portfolio (Dangl and Kashofer, 2013).
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The price volatility is also the degree to which price changes in one security result to changes in

another security within the same portfolio. An investment's uncertainty may be synonymous with

its market risk. As the risk of an investment increases, so does the risk of the market. It is

essential to define what a portfolio is what its components are when considering how an investor

can construct a portfolio of minimum variance.

A portfolio is described as a set of securities that an investor holds in a single account to

reduce the risk exposure (Heck, 2013). As pointed earlier, an investor requires an investment

opportunity where there is minimum risk exposure for a given level of return. The achievement

of such a position requires the investor to construct a portfolio with a set of securities that have

low volatility or a combination of volatile investments that have a low correlation. Investments

with low correlation are those that perform unexpectedly while exposed to a similar condition of

the market. Such an attempt is viewed as an appropriate illustration of diversification. Most of

the minimum variance portfolios differ from the traditional mix of stocks and bonds (Dangl and

Kashofer, 2013).

The importance of MVP

The modern portfolio theory that describes diversification in a different dimension

emphasizes mixing highly volatile securities with low correlation, rather than focusing on a mix

of low-risk (Bonds) and high risk (Stocks). An investor, therefore, benefits from risk hedging

that is derived from holding a set of volatile securities that are less correlated (Fabozzi, 2016).

The most critical aspect of the minimum variance portfolio is, therefore to build a portfolio of

assets that have low correlation such that price swings in one security do not adversely affect the

other security in the portfolio. A good example would be a comparison of two investors, one
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holding 100% small-cap stocks or 100% large-cap or 100% international stocks. And another

one holding 20% small-cap stocks, 30% large-cap stocks and 50% international market stocks.

The investor who owns 100% stocks of either type would be exposed to a high risk of volatility

considering individual stocks. The other investor who holds a portfolio of the different stocks

would hedge the risk of volatility since the securities have a low correlation with each other.

Such a portfolio is built on the idea that a decline in the price of small-cap would not affect the

international market.

Capital Asset Pricing Model (CAPM)

Fund managers focus on maximizing returns for investors. Investors commit their

current funds in anticipation of future returns. Therefore, the yield is a critical component of

investment decisions. The risk determines the return that investors require that an investor holds.

As such, the understanding of the relationship between systematic risk and return is critical while

making an investment decision. The estimation of the required rate of return is a central

component of an investment decision that needs to be accurately estimated (Heck, 2013).

CAPM appropriately estimates the required return rate using essential components of

investment appraisal (Dempsey, 2012). Such components include the risk-free rate, market

return, and market risk. For the entire discussion on portfolio optimization, the aspects of the

risk-free rate and systematic risk are central in maximizing the yield for investors. The same

components are applied in CAPM to estimate the investor’s required rate of return accurately.

Components of CAPM

The required rate of return is calculated as follows according to the model: E(ri)= Rf + βi

(E(rm)–Rf), where E(ri) is the actual rate of return; Rf is the risk-free rate; βi is a systemic risk,
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while E(rm) is the expected return on the business. The equation provides a linear relationship

between the systemic risk and the necessary rate of return (Dempsey, 2012). The model assumes

that unsystematic risk can be completely diversified; all investors have exposure to risk-free rate

knowledge and the capital markets are ideal markets. Though in reality, these assumptions are

not practicable, the model remains one of the most commonly used to predict the desired rate of

return. CAPM is preferred to other methods of determining the required rate of return since it

only accounts for systematic risk that cannot be diversified as well as providing a clear, standard

format that is easy to understand (Heck, 2013).

In conclusion, CAPM, SML, and CML are dominant concepts when it comes to

financial management. Financial managers need to understand how the components are related to

each other to help investors make an informed decision on how they invest their money. The

concepts are widely used and consider the fundamental aspects such as the systematic risk, risk

premium, the risk-free rate, as well as identifying how they are related to investors' required rate

of return. Understanding them is key to building efficient portfolios and maximizing returns

which is the goal of every investor.

References

Dangl, T. and Kashofer, M. (2013). Minimum-Variance Stock Picking - A Shift in Preferences

for Minimum-Variance Portfolio Constituents. SSRN Electronic Journal.

Dempsey, M. (2012). The Capital Asset Pricing Model (CAPM): The History of a Failed

Revolutionary Idea in Finance?. Abacus, 49, pp.7-23.

Fabozzi, F. (2016). Bond markets, analysis, and strategies. Boston: Pearson.

Heck, J. (2013). Investment analysis and portfolio management strategies. Bradford, England:

Emerald Group Pub.