Last Updated on October 27, 2023 by BFSLTeam BFSLTeam
Various analytical tools are available for investors to assess and understand stocks and trends of the share market. These tools offer valuable guidance to the investors who can utilise them to broaden their investment vision, limit the scope of risk, and increase the potential for profit. The Security Market Line and the Capital Market Line are two such valuable tools that you can use to limit the scope of risk associated with your investments. Read on to know in detail about the meaning of SML and CML and understand the major differences between the two market lines.
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What is the Capital Market Line (CML)?
The capital market line (CML) is a graphical representation that shows you the relationship between the risks and returns of different portfolios. It links the risk-free rate of return with a portfolio composed of risky assets. Unlike the SML, which focuses solely on individual assets, the CML incorporates the concept of diversification by combining a risk-free asset with a portfolio of risky assets. The risk-free asset is typically represented by government bonds, which are considered to have negligible default risk.
In simpler terms, the CML showcases the optimal portfolios that blend the risk-free asset with a diversified mix of risky assets. These optimal portfolios offer the highest return for each level of risk, thus enabling you to customise your portfolios according to your risk preferences.
What Does the Capital Market Line Tell You?
The CML offers a visual representation of the risk-return tradeoff that you face when you are constructing a portfolio consisting of different assets. It highlights the benefits of diversification and the potential to enhance returns without incurring excessive risk. The slope of the CML, known as the Sharpe ratio, quantifies the incremental return per unit of risk in the portfolio. So, the CML serves as a guide for building portfolios that balance the goal of earning higher returns with prudent risk management.
What is the Security Market Line (SML)?
The security market line (SML), much like the CML, is a graphical representation of the risk and expected returns of an asset. Unlike the CML, the SML focuses solely on individual assets rather than complete portfolios. It plots the relationship between an asset’s expected return and its systematic risk, which is measured by its beta. The beta captures an asset’s sensitivity to market movements and serves as a gauge for its systematic risk.
The SML is derived from the Capital Asset Pricing Model (CAPM), which asserts that an asset’s expected return should be proportional to its beta. Mathematically, the SML is represented as follows:
| E(Ri) = Rf + βi [E(Rm) — Rf] |
Here, the parameters used in the above equation mean the following:
- E(Ri) is the expected rate of return from the stock or asset
- Rf is the risk-free rate of return, i.e. the theoretical rate of return that carries zero risk
- βi is the systematic risk of the stock or asset
- E(Rm) is the expected rate of return from the market as a whole
- E(Rm) — Rf is known as the risk premium
What Does the Security Market Line Tell You?
The SML plays a critical role in assessing an asset’s valuation based on its risk. If an asset lies above the SML, it is considered undervalued, as it offers higher returns than its systematic risk justifies. Conversely, assets below the SML are overvalued, indicating that their expected returns do not adequately compensate for their risk.
The Key Differences Between CML and SML
Even though both the SML and the CML are market lines that compare risks and returns, here are the key differences between the CML and SML.
- Scope of the Market Line
The capital market line focuses on portfolios that consist of a mix of risky and risk-free assets. But the security market line only concentrates on individual assets like stocks.
- Components of the Market Line
The capital market line combines a risk-free asset with a portfolio of risky assets. But the security market line correlates an asset’s expected return to its systematic risk or beta.
- Applicability of the Market Line
If you are interested in constructing a diversified portfolio that optimises the risk-return tradeoff, the capital market line will be useful. But if you want to assess the valuation of individual assets based on their risk, the security market line is more suitable.
Also Read: Understanding Rolling Settlement in the Stock Market
SML vs CML: A Comparison
Let us tabulate the key differences between the CML and SML.
| Particulars | Security Market Line | Capital Market Line |
| Area of focus | Individual assets | Portfolios of risky as well as risk-free assets |
| Parameters used | Systematic risk i.e. beta | Diversification and risk-free rate |
| Primary application | Asset valuation and selection | Portfolio optimisation |
| Equation | E(Ri) = Rf + βi [E(Rm) — Rf] | E(Rp) = Rf + [{E(Rm) — Rf} ÷ σm] x σp |
| Risk-return tradeoff | Evaluates the risk-return tradeoff for a single asset | Helps build efficient portfolios with varying levels of risk |
Security Market Line vs Capital Market Line: Which Should You Use?
Determining which indicator to use between the SML and the CML depends on your specific investment objectives and needs. If you are focused on analysing individual assets and their valuation based on risk, the SML is your tool of choice. On the other hand, if you aim to construct a diversified portfolio that optimises the risk-return tradeoff, the CML provides a comprehensive framework.
In essence, both the SML and the CML serve distinct yet complementary purposes. The SML guides asset selection and valuation, while the CML facilitates the creation of well-balanced portfolios. As an investor, your choice between the two should align with your investment goals and the level of risk you are willing to undertake.
