Capital Market Line (CML) vs Security Market Line (SML)
Modern portfolio theory explores the ways in which investors can built their investment portfolios in a way that minimizes risk levels and maximizes returns and profits. The Capital Asset Pricing Model (CAPM) is an important part of portfolio theory that discusses the capital market line (CML) and security market line (SML). These concepts are quite complicated and can easily be misinterpreted. The following article offers a clear and simple understanding of what each CML and SML mean and outlines the similarities as differences between these two concepts.
What is Capital Market Line (CML)?
The capital market line is the line drawn from the risk free asset to the market portfolio of risky assets. The Y axis of the CML represents the expected return and X axis represents the standard deviation or level of risk. The CML is used in the CAPM model to show the return that can be obtained by investing in a risk free asset, and the increases in return as investments are made in more risky assets. The line clearly shows the levels of risk and return. The levels of return keep increasing as the risk undertaken increases. The CML, therefore, plays a part in assisting investors decide the proportion of their funds that should be invested in the different risky and risk free assets. Examples for risk free assets include treasury bills, bonds, and government issued securities, whereas risky assets can include shares, bonds, and any other security issued by a private organization.
What is Security Market Line (SML)?
The security market is the representation of the CAPM model in a graphical format. The SML shows the level of risk for a given level of return. The Y axis represents the level of expected return, and the X axis shows the level of risk represented by beta. Any security that falls on the SML itself is considered to be valued fairly so that the level of risk corresponds to the level of return. Any security that lies above the SML is an undervalued security as it offers greater return for the risk incurred. Any security below the SML is overvalued as it offers less return for the given level of risk.
Capital Market Line vs Security Market Line (CML vs SML)
The SML and CML are both concepts related to one another, in that, they offer graphical representation of the level of return that securities offer for the risk incurred. Both CML and SML are important concepts in modern portfolio theory and are closely related to CAPM. There are a number of differences between the two; one of the major differences is in how risk is measured. Risk is measured by the standard deviation in CML and is measured by the beta in SML. The CML shows the level of risk and return for a portfolio of securities, whereas SML shows the level of risk and return for individual securities.
Summary:
• The Capital Asset Pricing Model (CAPM) is an important part of portfolio theory that discusses the capital market line (CML) and security market line (SML).
• The CML is used in the CAPM model to show the return that can be obtained by investing in a risk free asset, and the increases in return as investments are made in more risky assets.
• The security market is the representation of the CAPM model in a graphical format. The SML shows the level of risk for a given level of return.
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