This report gives a brief account of the capital market line and the security market line . It also states the dissimilarities between them. The security is measured by a beta coefficient . The security market line virtually represents the capital market line .CML is a graph that shows all possible combinations along the expected portfolio.The above frontier consists of the combinations along the market portfolio and a risk free asset. The report make an indepth analysis of the two . Then it discourses the idea of minimum variance portfolio and its position in selecting stocks that enhance return and reduce risks. It also demonstrates the significance of CAPM .
The CML is a line that displays stock returns.. SML is a graph that symbolises the risk of the market at a fixed point of time. It depends on the risk free rate of return. It is also dependent on the levels of risk in association to a specific portfolio. Standard deviation measures the risk factor for CML(Ahmed and Zlate 2014). The beta coefficient measures the risk factor for SML. Security market line outlines both non efficient and efficient portfolios. The capital market line helps define efficient portfolios only (Christensen, Hail and Leuz 2016).
Figure 1- CML VS SML
Source-( Buera, Jaef and Shin 2015)
As per the graph , the Y axis shows the expected return that the portfolio intends to give. The Yaxis shows the return on the securities on the security market portfolio . The X axis dispalys the standard deviation portfolio for the CML. The beta is shown along with the X axis(Christensen, Hail, and Leuz 2016).
The differences between the security market line and capital market line can be illustrated as follows:
|
Capital market line |
Security market line |
|
It shows the rates of return in association with a particular portfolio that is particular |
It shows the risk and return of the market at a specified moment in time(Dey, Lahiri and Zhang 2014) |
|
The risk is measured by standard deviation |
The risk is measured by beta |
|
It determines efficient portfolios(Obamuyi 2013) |
It determines both non efficient and efficient portfolios |
|
It determines risk free assets and market portfolio |
It determines security factors associated with a particular stock(Hoijtink 2014). |
The equity portfolios are allocated in such a particular way. They are allocated in such a manner that it can have the lowest possible variances. This particular analysis is concerned about increasing the obligation that is related to management of risk . This is due to the the financial crisis. One more reason that could be interpreted is that very low volatile stocks have a propensity to exhibit returns which match or surpass the market(Yang, Couillet. and McKay 2015). The general volatility of other equity portfolios might get exaggerated if there is a possibility of significant downsides, which could be expected by the investor They may desire low volatility stocks. The investor in this case might consider himself as risk aware(Clarke, De Silva. and Thorley 2013). This particular investor will not even consider low volatility indexes.. The problem which he will face is choosing among different market capitalisation weighting schemes. These schemes cannot diminish the volatility that is required . The weighting approaches that are based on non capitalisation will attain a considerable reduction in volatility. The investor , if he so chooses may decide to decrease the aggregate volatility. (Bodnar, Mazur and Okhrin 2017)
Figure 2- Minimum variance portfolio
Source-( Bodnar, Mazur and Okhrin 2017)
The above graphical illustraton shows the modern portfolio theory. This suggests that there is a tangent to the optimal investment portfolio. This optimal portfolio is found at the point in where the efficient frontier intersects the CML. Since there is a low volatility , an investor may actually attain a portfolio that is above the efficient frontier . A risk averse investor wants a particular type of portfolio. He wants to have a portfolio that rests on the efficient frontier. This portfolio will be such that it has the maximum possible return and the minimum possible risk( Bodnar, Mazur and Okhrin 2017).
The importance of the minimum variance portfolio theory can be illustrated in the following way:
CAPM is a model that provides the best estimate of the relationship between expected return for assets and the level of systematic risk. It is used to generate the expected return for assets. This method is predominantly used to value securities of a risky nature(Smith. and Walsh 2013).
The main idea behind this model is the risk associated with various securities. It also computes the compensation amount .This is the amount which the investor needs so that he can sustain the additional risk that he has to bear in relation to this security . This can be evaluated by using beta. Beta compares the return of the asset to the return that the market gives over time . It reflects how risky the asset is.It considers the market premium . It also studies the percentage change or the excess amount that the market return has over the risk free rate.This risk is then compared to the volatility of the market . It incorporates a risk free premium. As per this model it is stated that the expected return of a security or portfolio is similar to that of the risk free security rate. This model also states that it would be prudent not to invest if for some reason ,the expected market return does not meet or beat the required return.(Campbell et al. 2018).
Some of the assumptions of the CAPM include:
Single period transaction – CAPM assumes a standardised holding period. of one year.This is used so that the comparison of return on different securities can be done.
Diversified portfolios- This point makes the claim that investors can diversify their investments, they can reduce their systematic risk This is because the diversification of the e unsystematic risk can be done and subsequently cannot be ignored.
Perfect capital market-A perfect capital market means that all the securities are valued at the rate at what they should be valued..In a perfect market, there is a lack of tax or transaction costs . Their returns will be plotted on the SML The perfect capital market assumes that there is free information is available to all investors. However it can be stated that capital markets are not perfect in nature. The return on securities are usually mentioned annually. The one year holding period assumption may appear to be reasonable from the perspective of the real world. However in reality the investors hold securities for more than a year.
CAPM is indeed more relevant than other companies when calculating the rates of return for expected return on assets. These include:
From the report there are certain recommendations that are as follows:
Conclusion
It is evident from the report that the security market line is indeed different than the capital market line . The differences highlight the uniqueness of the two concepts. A minimum variance portfolio analysis is also done. This analysis considers the minimum variance portfolio . Now the minimum variance portfolio has been found to be a suitable method for selecting stocks. These stocks have ideal returns and minimum risk variance. From the CAPM discussion, it is evident that it is a more relevant method than other equations than the required rate of return. It helps in measuring the return on asset by associating the beta. This beta is a measure of systematic risk . This systematic risk is combined when one is calculating the rate of return on a security using the CAPM. It also helps in figuring the cost of equity. The CAPM is the best method while determining return on risky securities. It is based on a theoretical approach that best determines systematic risk and eliminates unsystematic risk. So it is more effective in computing prices of securities.
References
Ahmed, S. and Zlate, A., 2014. Capital flows to emerging market economies: a brave new world?. Journal of International Money and Finance, 48, pp.221-248.
Bodnar, T., Mazur, S. and Okhrin, Y., 2017. Bayesian estimation of the global minimum variance portfolio. European Journal of Operational Research, 256(1), pp.292-307.
Buera, F.J., Jaef, R.N.F. and Shin, Y., 2015. Anatomy of a credit crunch: from capital to labor markets. Review of Economic Dynamics, 18(1), pp.101-117.
Campbell, J.Y., Giglio, S., Polk, C. and Turley, R., 2018. An intertemporal CAPM with stochastic volatility. Journal of Financial Economics, 128(2), pp.207-233.
Christensen, H.B., Hail, L. and Leuz, C., 2016. Capital-market effects of securities regulation: Prior conditions, implementation, and enforcement. The Review of Financial Studies, 29(11), pp.2885-2924.
Clarke, R., De Silva, H. and Thorley, S., 2013. Risk parity, maximum diversification, and minimum variance: An analytic perspective. The Journal of Portfolio Management, 39(3), pp.39-53.
Dekker, H.A., 2017. The invisible line: land reform, land tenure security and land registration. Routledge.
Dempsey, M., 2013. The capital asset pricing model (CAPM): the history of a failed revolutionary idea in finance?. Abacus, 49, pp.7-23.
Dey, D., Lahiri, A. and Zhang, G., 2014. Quality Competition and Market Segmentation in the Security Software Market. Mis Quarterly, 38(2).
Hoijtink, M., 2014. Capitalizing on emergence: The ‘new’civil security market in Europe. Security Dialogue, 45(5), pp.458-475.
Maio, P., 2013. Intertemporal CAPM with conditioning variables. Management Science, 59(1), pp.122-141.
Obamuyi, T.M., 2013. Factors influencing investment decisions in capital market: A study of individual investors in Nigeria. Organizations and markets in emerging economies, 4(1), pp.141-161.
Smith, T. and Walsh, K., 2013. Why the CAPM is Half?Right and Everything Else is Wrong. Abacus, 49, pp.73-78.
Yang, L., Couillet, R. and McKay, M.R., 2015. A robust statistics approach to minimum variance portfolio optimization. IEEE Transactions on Signal Processing, 63(24), pp.6684-6697.
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