Key Points of Distinction between CML and SML

The paper would focus on the various corporate finance aspects that take into consideration capital market line (CML), security market line (SML), minimum variance portfolios and capital asset pricing model (CAPM). The investors use these models for creating a portfolio containing various stocks depending on which they would undertake their investment decisions (Aliu, Pavelkova and Dehning, 2017). Firstly, the paper would concentrate on analysing the key points of distinction between CML and SML through graphs. The next segment would lay stress on explaining the use of minimum variance portfolios so that the investors could evaluate the risk and return associated with investment decisions. Lastly, the assignment would focus on describing the CAPM relevance over other models for computing required rate of return on a particular investment.

In order to highlight the differences between SML and CML, graphical illustrations are taken into consideration.

Figure 1: Efficient frontier

(Source: Chandra, 2017)

From the above figure, it is evident that the investor has the option of investing either in points B and C or in points A and B. Moreover, with the help of this figure, it is possible to identify the investor preference so that the individual could invest in securities between B and C. Even though the risk level of the two options is identical, the return on stock C would be greater than the return on stock A would be higher than the return on stock C. Therefore, the investor would prefer investing on C rather than A.

Figure 2: Capital market line (CML)

(Source: Chandra, 2017)

All the investors are needed to take into consideration risky as well as non-risky securities so that the portfolio could be formed (DeFusco, et al., 2015). The above figure represents the CML in the form of a straight line, which is denoted by R_fS’. The line represents the assets that are devoid of risk and the line initiating from S to S’ includes risky investments as well as borrowing portfolio. Hence, it could be said that a linear relationship is depicted by CML between the required return for efficient portfolios and their related standard deviations. The portfolios represented on CML disclose the risk price through the line slope and the projected return above the risk-free rate would be in line to the standard deviation associated with the portfolio in terms of the market, which is adjudged as the market portfolio.

Use of Minimum Variance Portfolios

On the contrary, the security market line (SML) and efficient portfolios measured by CML represents the risk that the inefficient portfolios are not depicted in CML and thus, the association between risk and return could not be analysed (Damodaran, 2016). Another key contribution made by SML is related to the measurement of individual stock irrespective of their efficiency level. Along with this, the SML determines the projected returns for a stock beta and this assists in measuring the systematic risk. Although the unsystematic risk could be diversified because there is no association with the market, the beta risk could not be diversified, which needs considerable assessment.

Figure 3: Evaluation of stocks with SML

(Source: Domowitz and Giritharan, 2017)

The over-priced and under-priced securities are possible to be determined through SML. From the above figure, the under-priced stocks could be identified, which lie above the SML. The three stocks that are under-priced include X, Y and Z, while the three stocks that are over-priced include U, V and W, as they are below the SML. However, dissimilarity could be observed between the two classes of stocks despite the fact that they carry same risk level. This is because the under-priced stocks provide greater returns compared to over-priced stocks. In order to prove that the stocks X, Y and Z are under-priced, the formula seen in the above figure could be applied. As per the formula, the current price is P₁, the purchase price is P₀ and dividend is represented by Div. There are three stocks A, B and C lying on the SML and hence, their stock price is accurate and they contain same levels of risk and return.

Figure 4: SML in imperfect market

(Source: Gandhi, 2015)

If perfect information is not available, there would be direct impact on stocks. The reason is that full information is available in a perfect market and the stock lie exactly on the SML. However, the SML takes the form of a band in an imperfect market, instead of a single line, which is represented in the above figure.

By taking into consideration all the above-mentioned aspects, the key differences between SML and CML are summarised as follows:

Points of dissimilarities	Security Market Line (SML)	Capital Market Line (CML)
Concept	It is denoted by a line where the market risk and return is plotted at a specific timeframe.	It is denoted by a line where a specific portfolio return is plotted.
Efficiency	SML considers both efficient and inefficient portfolios.	CML only considers efficient portfolio.
Stock or portfolio	SML determines risk and return related to individual stocks.	CML determines risk and return related to efficient portfolios (Kevin, 2015).
Risk measurement	In order to measure risk, standard deviation is used.	In order to measure risk, beta is used.

A minimum variance portfolio is the stock portfolio, which is merged for minimising the price volatility of the overall portfolio. There would be rise in market risk, if there is increase in volatility of an investment (Ouenniche, et al., 2016). Hence, from the perspective of an investor, for risk minimisation, ups and downs are to be reduced as well. With the help of minimum variance portfolio, the lower bond associated with the efficient frontier could be determined. Despite the fact that there are portfolios carrying investment opportunity, certain portfolios are deemed to be inefficient (Post and Potì, 2016). This signifies that a certain portfolio contains equal risk; however, the returns of some stocks are higher than the others. Therefore, there would not be any investor willing to invest in portfolio lying beneath the minimum variance portfolio. With the help of systematic portfolio optimisation, diversification and efficiency could be improved. The minimum variance portfolio is extremely important for the investors due to the following reasons:

Relevance of CAPM over Other Models

Low risk:

As efficient frontier is close to the minimum variance portfolio, there could be better comparison of risk-return ratio (Sharpe ratio) with the index. Thus, with the help of optimised diversification, there would be minimisation in portfolio volatility and losses at the time of correcting the market (Render, et al., 2017).

Higher return and volatility premium:

In the words of Satyanarayana, Sidhu and Chary (2017), the securities with lower price fluctuations achieve average returns and they are higher than the projected returns. For the last 40 years, the low volatility premium has been documented. The minimum variance portfolio helps in effective implementation of the same due to the consideration of associations between individual investments.

Projections of minimum variance portfolio:

As the minimum variance portfolio is the only portfolio on the efficient frontier dependent on risk parameters, it is possible to model the same. Hence, it becomes possible to make projections over time through econometric methods. Moreover, there is no need for the return projections.

Sustainability:

The investors take into account governance, environmental and social criteria, while undertaking investment decisions. Hence, this mandates the need for the organisations in fulfilling certain criteria for staying the investment world. These criteria take into consideration adherence to UN Global Compact, green flag as well as ESG rating. In addition, minimum variance portfolio takes into account sustainability ratings at the overall portfolio level so that the investors obtain assistance in making decisions.

Figure 5: Minimum variance portfolio

(Source: Stettina and Hörz, 2015)

Capital asset pricing model (CAPM) is the linear association between the return required on investment and systematic risk. The following formula is used to represent the CAPM model:

Figure 6: CAPM formula

(Source: Thomas, 2014)

From the above figure, CAPM formula could be observed that the investors use to determine their projected investment returns. Along with this, CAPM assists in the calculation of weighted average cost of capital (WACC). WACC is used as the rate of discount in appraising investment appraisals; however, there needs to be fulfilment of certain assumptions, which are enumerated briefly as follows:

• The investment project should not be more than the investing firm
• There needs to be similarities between the business activities of the project and those of the investing organisation
• There needs to be similarities in the financing mix utilised in the project and the capital structure of the investing company.
• The existing fund providers of the organisation should maintain the same rates of return after the project has been undertaken.

Depending on these assumptions, the discount rate could be used, if the business risk and financial risk of the organisation are not changed by the investment project. If dissimilarities are observed between the business risk of project and the organisation, CAPM could be utilised for arriving at a rate of discount particular to the project. Hence, it could be said that CAPM assists in better and sound investment decisions, instead of WACC, which is represented with the help of the below-stated figure:

Graphical Illustrations to Highlight the Differences between Two Market Lines

Figure 7: WACC versus CAPM

(Source: Williams and Dobelman, 2017)

Based on the above figure, it is inherent that Project A would not be accepted, if WACC is utilised as the discount rate due to the fact that the IRR is lower than the WACC. However, this decision is not deemed to be correct when investment decision would be taken. The reason is that as Project A’s IRR is plotted above SML, it needs to be accepted and this is evident when the CAPM discount rate is utilised. Hence, it could be stated that Project A fetches greater return in contrast to the one required for compensation with the level of systematic risk and if it is accepted, the value of the shareholders would increase. On the contrary, WACC approach suggests the acceptance of Project B. This is not an accurate decision, as the CAPM discount rate rejects this project to be undertaken. The reason is that the IRR does not offer adequate compensation for its level of systematic risk.

The models like dividend discount model, Fama French model and Gordon growth model are considered as alternatives to CAPM. The investors use these models to calculate the rate of return that would assist in improving their decision making process. However, most of these models need critical calculations and statistical data and as a result, difficulties are encountered for making investment decisions (Wu, Wermers and Zechner, 2016). Hence, CAPM is preferred over the above-stated models due to the fact that it provides the following benefits:

• CAPM considers systematic risk representing a reality, in which diversified portfolios are held by numerous investors, which have assisted in eliminating unsystematic risk.
• Under CAPM, it is possible to compute the cost of equity effectively compared to the dividend growth model. This is because CAPM considers the level of systematic risk of the entities associated with the stock market (Van Duuren, Plantinga and Scholtens, 2016).
• Better appraisal of investment projects is possible with the help of CAPM in relation to discount rate calculation in comparison to WACC.

Conclusion:

The above discussion clearly makes it evident that SML, minimum variance portfolios and CML have depicted the levels of measurement that makes it possible for the investors to use in making their investment decisions. It has been identified that the investors would not intend to invest in portfolios that are beneath the minimum variance portfolios. With the help of optimisation of systematic portfolio, diversification and efficiency could be improved. Furthermore, it has been assessed that CAPM assists in effective computation of the rate of return that is difficult to compute under the other models. Hence, it could be stated CAPM could be utilised for increasing the overall value of the shareholders.

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