The present study is based on evaluation advance concepts of investment portfolio management in order to gain an understanding for making better investment decisions. In the first part, the study will cover the difference between Security Market Line and Capital Market Line by considering proper graph and its interpretation. Further, discussion of minimum variance portfolio and its significance will be done by making use of relevant examples. In the last part of the study; relevancy of CAPM model will be discussed in comparison to another model available for computation of return on investment.
The capital market line arises from the integration of free of risk asset and the market portfolio. Every point together with the CML has premium profiles of risk-return to the portfolio on the effective edge (Asness, Frazzini and Pedersen, 2012). Derivation of CML is held by drawing a tangent line from the point of intercept upon the efficient frontier till when the expected return is equivalent to the free of risk rate of return (Hodnett and Hsieh, 2012).
A line is put in use in the pricing approach of a capital asset to demonstrate the return rates for the efficient portfolio based on the free of risk rate of return and the risk level, i.e., standards deviation for a specified portfolio (Lee and Su, 2014).
The CML is stated to be top-notch to the efficient frontier, as it considers the addition of risk-free asset within the portfolio (Brown, 2012). The CAPM which stands for capital asset pricing model illustrates that essentially the market portfolio is the efficient frontier.
Formula: E(Ri) = RF + SDc×{E(RM)-RF}/SDm
In which the SDC refers to a portfolio standard deviation C return, while the SDM is regarded as a market-return standard deviation.
Figure 1: Capital market line graph
(Source: Sharpe, 2017)
The security market line refers to the related graphical representation of the CAPM. It reflects the expected return rate of own security as a characteristic of structural and non-divisible risk (Painter, 2010). While using SML in portfolio management, it shows the opportunity cost of investments that means making an investment in the integration or market portfolio and asset free of risk (Avadhani, 2010). The SML’s Y-intercept is equivalent to the risk-free rate of interest. The SML slope is equivalent to the market risk premium and states the risk-return trade-off at the specified time.
Formula: E( Ri) = RF + bi×{E(RM)-RF}
In which the E (Ri) is regarded as an expected return of security, the risk-free rate is the RF, and the beta coefficient of security is abbreviated as bi, and the E (RM) means the expected market return.
Figure 2: Security market line
(Source: Sharpe, 2017)
|
Under-priced |
Expected return > required a return as per the CAPM · lies above the SML |
|
Overpriced |
Expected return<required return as per the CAPM · lies below the SML |
|
Correctly priced |
Expected return=required return as per the CAPM · lies along the SML |
The major dissimilarity between the Capital Market Line (CML) and Security Market Line (SML) is dependent on the calculation of the risk factor associated with the portfolio. Above mentioned (CML) measures the risk by standard deviation, while in another line (SML) risk factor conclude by the Beta Coefficient (Avadhani, 2010). Along with CML line, determine risk factor also by the method total risk factor.
On the opponent line above (SML) measures the risk throughout the beta, and it helps to locate the Security’s risk Contribution for the Portfolio. The CML, on the other hand, creates the rates of return furthermore it is based on the risk-free rates of return also with the risk for a special portfolio (Hodnett and Hsieh, 2012). SML line is also known as the “characteristic Line”, which is a graphical illustration of market’s risk and return to a specific time. An efficient portfolio can be classified by the capital market line (CML), whereas, Security Market Line (SML) labialized as both efficient as well as non-efficient portfolios (Asness, Frazzini and Pedersen, 2012). Whenever measuring the risk factors above the stated line (CML) is considered as superior to another one. The mentioned line (CML) is resolute by the market portfolio and risk-free assets, on other hand security market line is determined the factors of different security available in financial markets.
The Capital market line illustrates defined effective portfolio, and both effective and non-effective portfolio is defined by the graph. When the returns are computed, the CML portfolios expected return is demonstrated on the Y-axis (Antoniou, Doukas and Subrahmanyam, 2015). On the contrary to this, for SML, the securities return is presented with the
Y-axis, whereas for CML, The portfolio standard deviation is presented on the X-axis and for SML, the Beta of security is represented on the X-axis.
Statement showing key differences among CML and SML
|
Capital market line |
Security market line |
|
CML can be termed as graphical representation of CAPM which shows connection between total risk and proposed return from the efficient portfolio. |
SML can be termed as graphical representation of CAPM which shows connection between systematic risk and return expected from individual stock asset. |
|
In this, measurement of risk is done through standard deviation which is also known as total risk factor. |
In this, measurement of risk is done through beta as it assist in determining risk contribution of security to the portfolio. |
|
This graph defines merely efficient portfolio. |
This graph defines merely efficient as well as non-efficient portfolio. |
The market portfolio and assets which are free of risks are identified by CML whereas SML identifies the security variables (Bierman and Smidt, 2012).
The minimum variance portfolio can be defined as the risk-based approach used for the construction of the portfolio. This concept indicates while forming portfolio instead of considering the risk and return simultaneously; only risk is to be used in constructing portfolio (Bodnar, Parolya and Schmid, 2018). This approach is viable for investors as the determination of future returns is not an easy task and estimations made are not accurate in all cases. Consideration of this aspect leads to forming a more robust portfolio that is less subjected to estimation of risk. Computation of weights can be done by using following formula for forming minimum variance portfolio for two assets:
Variance = (w(1)^2 xo(1)^2) + (w(2)^2 xo(2)^2) + (2 x (w(1)o(1)w(2)o(2)q(1,2))
In this formula
w (1) = the weight of the first asset in the portfolio
w (2) = the weight of the second asset in the portfolio
o (1) = the standard deviation of the first asset in the portfolio
o (2) = the standard deviation of the second asset in the portfolio
Cov (1,2) = the covariance of the portfolio for two assets, this can be sampled to q(1,2)o(1)o(2), where q(1,2) is the correlation between the two assets selected for the portfolio
Figure 3: Frontier of Minimum variance portfolio
(Source: Breaking down finance, 2018)
A minimum variance portfolio is meant as a securities portfolio that integrates to reduce the price volatility of the portfolio as a whole (Clarke, Silva and Thorley, 2011). Further, volatility is a term used in substitute of the variance in the community of investment; it is a statistical related means of a specified price movement of a security.
The volatility within an investment is similar in definition with the market risk. Thus, the higher the volatility within an investment, the broader the price fluctuations and greater the market risk (Chow, Kose and Li, 2016). Further, an investor is willing to reduce the risk, and then they are also willing to reduce the price fluctuations.
Perhaps one of the most understandable examples of the minimum variance portfolio can be an integration of stock mutual fund with the bond mutual fund (Bodnar, Parolya and Schmid, 2018). In a situation where there is a rise in stock prices, the bond price might be slightly negative, while when there is fall in stock prices, in turn, the bond price will rise. Both stocks and bonds do not generally flow in the opposite direction. However, they have a lower correlation in context with performance.
By making use of the strategy of minimum variance portfolio in an optimal manner, an investor can integrate risk-based assets or investments form, and can still attain relatively higher returns with no relative risk engaged.
The rationale behind the OLZ investment philosophy is to make improvement in the portfolio composition in the classes of asset. Identifying the better weighting of the own investment is based on forecasted risk parameters such as volatilities and correlations. In doing so, OLZ considers current findings and outcomes of financial market research. Structured portfolio optimization enhances effectiveness and diversification that means reduced risk and enhanced returns.
Less risk is involved due to the optimized diversification; the minimum variance portfolio is positioned nearer to the efficient frontier and an optimal return-risk ratio as compared to the index (Bodnar and Gupta, 2015). Better diversification offers less volatility in portfolio thereby considerably reduced losses while conducting market corrections.
Higher return is attained due to the lower volatility premium; it is confirmed by empirical financial market studies that inventories having reduced price ups and downs can achieve higher returns. Further, the low volatility premium can be used by making use of minimum variance portfolio in an optimal manner, due to the correlation among own investments are also considered.
RRR which stands for required rate of return is an element in a lot of metrics implemented in company finance and valuation of equity. The RRR depicts the requirement of profit in commencing a project or investment (Fonseca, 2017). Further, RRR could be implemented in order to aid investors in making a decision if or if not they shall proceed in purchasing security. On the other hand, company executive and the finance expertise compute the RRR for investments inclusive of the purchase of possible merger & acquisitions and production-related equipment’s.
The Capital asset model is regarded as an asset which depicts the connection between investment risk and expected return in security (Coqueret, 2015). It reflects that the security’s expected return is equivalent to risk-free return add risk premium, which is done on the basis of the beta of the same security. The CAMP concept is represented as below:
Figure 4: Capital asset pricing model
(Source: Suntraruk, 2018)
The formula of CAPM is broadly used in the financial sector by several occupations like an accountant, investment bankers and financial analysts (Fernandez, 2015). It is considered as an important aspect of the weighted average cost of capital as CAPM helps in calculating the equity costs.
The formula of CAPM has continued in viable over 40 years of investment analysis due to its various benefits in comparison to other methods (Coqueret, 2015). One of the major reason, due to which CAPM is viable that it solely focused on systematic risk while computing rate of return (Zabarankin, Pavlikov and Uryasev, 2014). This factor indicates the realism that diversified portfolios fundamentally disregarded all the unsystematic risk stanching from characteristics of individual asset investment (Fonseca, 2017). This presumption is valid because; diversification of systematic risk cannot be done, and it is integral to the entire stock market or to the particular market segment.
WACC is also used immensely in the financial model; it can be implemented to look out for the NPV and future cash inflows and outflows of the made investment. Additionally, it computes the entity’s value and ultimately reaches computing equity value (Zabarankin, Pavlikov and Uryasev, 2014).
CAPM comes with various benefits; it is a calculation which is simple to use that can be easily tested to gain a variety of potential results for providing confidence with the RRR. CAPM considers systematic risk, which is apart from other methods, like dividend discount model. It is also known as market risk and is considered as a significant factor, as it is unexpected and generally it is not possible to entirely mitigate it as it is not completely expected. The theory that investors retain a diversified portfolio, same as the market portfolio makes reduction the unsystematic risk (Suntraruk, 2018). While business lookout for opportunities, is the mix of business and financial aspects vary from the existing business, then the other calculations of required return such as the WACC cannot be implemented, but CAPM can be used (Coqueret, 2015).
CAPM model assists investors to determine the price they should pay for the particular security by determining its fair price. For example, one stock is comparatively riskier than other stock; the price of the stock will also fluctuate as per the risk. Same aspects are applied to the rate of return provided by stock; higher the rate indicates higher market price and vice versa (Zabarankin, Pavlikov and Uryasev, 2014). Therefore; this model is generally used for the purpose of determining fair price of investment to be made by the investor. In situation; where investor determines the return on risk assets, they can apply time value of money to compute the present value of investment in order to make a viable choice. By extending this analysis, an investor can compare their fair to market value and can plan for bargain strategies as per the concerned case of overstatement or understatement.
It can be said that no model is ideal, but every model has its own traits that make them applicable and beneficial. CAPM has been criticized for its unreasonable estimations, offers highly useful results as compared to DDM or WACC, in most of the events (Dhrymes, 2017). The calculation of CAPM is easy, and while using it in conjunction with other investment mosaic aspects, it can offer supreme yield data, supporting or reducing a possible investment.
Conclusion
In accordance with the present study; conclusion can be drawn that it is important for investors to understand each and every factor of tools and components of investment in order to have a better understanding of the market. Study concludes that the primary dissimilarity between the Capital Market Line and Security Market Line is reliant on on the calculation of the risk factor associated with the portfolio. Further; the market portfolio and security assets which are free of risks are identified by CML whereas SML identifies the security variables. The present study shows that by using of suitable tools like CAPM and minimum variance portfolio investor can make suitable choice to get desire return within their risk appetite.
References
Hodnett, K. and Hsieh, H.H., 2012. Capital market theories: Market efficiency versus investor prospects. The International Business & Economics Research Journal (Online), 11(8), p.849.
Brown, R., 2012. Analysis of investments & management of portfolios.
Painter, M.J., 2010. The portfolio diversification impact of a farmland real estate investment trust. The International Business & Economics Research Journal, 9(5), p.115.
Avadhani, V.A., 2010. Investment management. Himalaya Publishing House.
Asness, C.S., Frazzini, A. and Pedersen, L.H., 2012. Leverage aversion and risk parity. Financial Analysts Journal, 68(1), pp.47-59.
Bierman Jr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. Routledge.
Antoniou, C., Doukas, J.A. and Subrahmanyam, A., 2015. Investor sentiment, beta, and the cost of equity capital. Management Science, 62(2), pp.347-367.
Sharpe, W., 2017. Capital Market Theory, Efficiency, and Imperfections. Quantitative Financial Analytics: The Path to Investment Profits, p.445.
Fonseca, R.J., 2017, September. Capital Asset Pricing Model—A Structured Robust Approach. In International Conference on Optimization and Decision Science (pp. 385-392). Springer, Cham.
Suntraruk, P., 2018. A simple test pf the CAPM Model under Bull and Bear market conditions. AU Journal of Management, 6(1), pp.62-70.
Fernandez, P., 2015. CAPM: an absurd model. Business Valuation Review, 34(1), pp.4-23.
Zabarankin, M., Pavlikov, K. and Uryasev, S., 2014. Capital asset pricing model (CAPM) with drawdown measure. European Journal of Operational Research, 234(2), pp.508-517.
Dhrymes, P.J., 2017. Portfolio Theory: Origins, Markowitz and CAPM Based Selection. In Portfolio Construction, Measurement, and Efficiency (pp. 39-48). Springer, Cham.
Bodnar, T. and Gupta, A.K., 2015. Robustness of the inference procedures for the global minimum variance portfolio weights in a skew-normal model. The European Journal of Finance, 21(13-14), pp.1176-1194.
Bodnar, T., Parolya, N. and Schmid, W., 2018. Estimation of the global minimum variance portfolio in high dimensions. European Journal of Operational Research, 266(1), pp.371-390.
Clarke, R., De Silva, H. and Thorley, S., 2011. Minimum-variance portfolio composition. Journal of Portfolio Management, 37(2), p.31.
Chow, T.M., Kose, E. and Li, F., 2016. The impact of constraints on minimum-variance portfolios. Financial Analysts Journal, 72(2), pp.52-70.
Coqueret, G., 2015. Diversified minimum-variance portfolios. Annals of Finance, 11(2), pp.221-241.
Lee, M.C. and Su, L.E., 2014. Capital Market Line Based on Efficient Frontier of Portfolio with Borrowing and Lending Rate. Universal Journal of Accounting and Finance, 2(4), pp.69-76.
Breaking down finance, 2018. Minimum variance portfolio. Available through < https://breakingdownfinance.com/finance-topics/modern-portfolio-theory/minimum-variance-portfolio/>. [Accessed on 22nd May 2018].
Essay Writing Service Features
Our Experience
No matter how complex your assignment is, we can find the right professional for your specific task. Contact Essay is an essay writing company that hires only the smartest minds to help you with your projects. Our expertise allows us to provide students with high-quality academic writing, editing & proofreading services.
Free Features
Free revision policy
$10Free bibliography & reference
$8Free title page
$8Free formatting
$8How Our Essay Writing Service Works
First, you will need to complete an order form. It's not difficult but, in case there is anything you find not to be clear, you may always call us so that we can guide you through it. On the order form, you will need to include some basic information concerning your order: subject, topic, number of pages, etc. We also encourage our clients to upload any relevant information or sources that will help.
Complete the order form
Once we have all the information and instructions that we need, we select the most suitable writer for your assignment. While everything seems to be clear, the writer, who has complete knowledge of the subject, may need clarification from you. It is at that point that you would receive a call or email from us.
Writer’s assignment
As soon as the writer has finished, it will be delivered both to the website and to your email address so that you will not miss it. If your deadline is close at hand, we will place a call to you to make sure that you receive the paper on time.
Completing the order and download