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Your CAL will be different from mine (has a different slope) because we have
different risk preferences and objectives.
I may be more risk averse than you and invest 20 % in rf and 80 % in a risky
portfolio. Hence we will draw different CALs.
CML:
All the points on the CAL are combinations of the rf and a risky portfolio which
varies from person to person according to his/her risk preferences.
All the points on the CML are combinations of the rf and market portfolio which is
the same for each person.
If you can only invest in risky assets : the efficient frontier is the upper portion of
the minium variance frontier. All points on the efficinet frontier are combinations
of risky assets that generate the highest return for a given level of risk.
if you can invest in risky assets and the rf asset : the efficient frontier is the CML.
Remember, the CML connects the rf asset with the risky (market) portfoliohence
all the points on this line segment are combinations of the rf and the market
portfolio.
SML :
Graphical representation of the notion embodied in the CAPM, that expected asset
returns are linearly related to systematic risk. The greater the systematic risk (Beta)
-> the greater the expected return to a risky asset.
This is due to the fact that investors need to be compensated for assuming more
systematic risk, the kind of risk that cannot be diversified away by holding a
portfolio of diverse assets (i.e.assets that have a less than +1 correlation).
The SML is a simple tool for determining whether an asset offers reasonable
expected return for the systematic risk it entails.
A security plotting above the SML is undervalued ( its return is higher than it
should be given its systematic risk implying that its price is lower than it should
be )
A security plotting below the SML is overvalued (its return is lower than it should
be given its systematic risk implying that its price is higher than it should be )
Also remember : the risk measure used by CAL/CML is the standard deviation of
asset returns while that used by the SML is the systematic risk
CML vs SML
CML stands for Capital Market Line, and SML stands for Security Market Line.
The CML is a line that is used to show the rates of return, which depends on risk-
free rates of return and levels of risk for a specific portfolio. SML, which is also
called a Characteristic Line, is a graphical representation of the markets risk and
return at a given time.
One of the differences between CML and SML, is how the risk factors are
measured. While standard deviation is the measure of risk for CML, Beta
coefficient determines the risk factors of the SML.
The CML measures the risk through standard deviation, or through a total risk
factor. On the other hand, the SML measures the risk through beta, which helps to
find the securitys risk contribution for the portfolio.
While the Capital Market Line graphs define efficient portfolios, the Security
Market Line graphs define both efficient and non-efficient portfolios.
While calculating the returns, the expected return of the portfolio for CML is
shown along the Y- axis. On the contrary, for SML, the return of the securities is
shown along the Y-axis. The standard deviation of the portfolio is shown along
the X-axis for CML, whereas, the Beta of security is shown along the X-axis for
SML.
Where the market portfolio and risk free assets are determined by the CML, all
security factors are determined by the SML.
Unlike the Capital Market Line, the Security Market Line shows the expected
returns of individual assets. The CML determines the risk or return for efficient
portfolios, and the SML demonstrates the risk or return for individual stocks.
Well, the Capital Market Line is considered to be superior when measuring the risk
factors.
Summary:
1. The CML is a line that is used to show the rates of return, which depends on
risk-free rates of return and levels of risk for a specific portfolio. SML, which is
also called a Characteristic Line, is a graphical representation of the markets risk
and return at a given time.
3. While the Capital Market Line graphs define efficient portfolios, the Security
Market Line graphs define both efficient and non-efficient portfolios.
4. The Capital Market Line is considered to be superior when measuring the risk
factors.
5. Where the market portfolio and risk free assets are determined by the CML, all
security factors are determined by the SML.
3. There are no restrictions on short sales (selling securities that you don't yet
own) of any financial asset.
5. All financial assets are fully divisible (you can buy and sell as much or as
little as you like) and can be sold at any time at the market price.
OR
1. Aim to maximize economic utilities (Asset quantities are given and fixed).
5. Can lend and borrow unlimited amounts under the risk free rate of interest.
7. Deal with securities that are all highly divisible into small parcels (All assets
are perfectly divisible and liquid).
There is evidence to support the idea that investors are basically risk averse. People
buy insurance on valuable assets. People expect a higher yield on bonds that are
lower in priority when it comes to repayment. The assumption of risk aversion
leads to the conclusion that in order to entice someone to take a larger risk, he must
be compensated with a higher expected rate of return, or else he won't do it.
WHY IT MATTERS:
In other words, modern portfolio theory is the formula that explains both why and
how a portfolio should be diversified, and -- as mentioned above -- the assumption
that investors are risk averse is an underpinning of modern portfolio theory.
The capital allocation line (CAL), also known as the capital market link (CML), is
a line created on a graph of all possible combinations of risk-free and risky assets.
The graph displays to investors the return they might possibly earn by assuming a
certain level of risk with their investment. The slope of the CAL is known as the
reward-to-variability ratio.
An easy way to adjust the risk level of a portfolio is to adjust the amount invested
in the risk-free asset. The entire set of investment opportunities includes every
single combination of risk-free and risky assets. These combinations are plotted on
a graph where the y-axis is expected return and the x-axis is the risk of the asset as
measured by standard deviation.
The simplest example is a portfolio containing two assets: a risk-free Treasury bill
and a stock. Assume that the expected return of the Treasury bill is 3% and its risk
is 0%. Further, assume that the expected return of the stock is 10% and its standard
deviation is 20%. The question that needs to be answered for any individual
investor is how much to invest in each of these assets. The expected return (ER) of
this portfolio is calculated as follows:
The calculation of risk for this portfolio is simple because the standard deviation of
the Treasury bill is 0%. Thus, risk is calculated as:
In this example, if an investor were to invest 100% into the risk-free asset, the
expected return would be 3% and the risk of the portfolio would be 0%. Likewise,
investing 100% into the stock would give an investor an expected return of 10%
and a portfolio risk of 20%. If the investor allocated 25% to the risk-free asset and
75% to the risky asset, the portfolio expected return and risk calculations would be:
The slope of the CAL measures the trade-off between risk and return. A higher
slope means that investors receive higher expected return in exchange for taking on
more risk. The value of this calculation is known as the Sharpe ratio.
The capital market line (CML) appears in the capital asset pricing model to depict
the rates of return for efficient portfolios subject to the risk level (standard
deviation) for a market portfolio and the risk-free rate of return.
The capital market line is created by sketching a tangent line from the intercept
point on the efficient frontier to the place where the expected return on a holding
equals the risk-free rate of return. However, the CML is better than the efficient
frontier because it considers the infusion of a risk-free asset in the market portfolio.
The capital asset pricing model (CAPM) proves that the market portfolio is the
efficient frontier. It is the intersection between returns from risk-free investments
and returns from the total market. The security market line (SML) represents this.
The capital asset pricing model determines the fair price of investments. Once
the fair value is determined, it is compared to the market price. A stock is a good
buy if the estimated price is higher than the market price. However, if the price is
lower than the market price, the stock is not a good buy.
In the CAPM, the securities are priced, so the expected risks counterbalance the
expected returns. There are two components needed to generate a CAPM, CML
and the SML. The capital market line conveys the return of an investor for a
portfolio. The capital market line assumes that all investors can own market
portfolios.
Single assets and nonefficient portfolios are not depicted on the CML.
Alternatively, the SML must be used. The capital market line permits the investor
to consider the risks of an additional asset in an existing portfolio. The line
graphically depicts the risk top investors earn for accepting added risk.
Separation Theorem
All investors have portfolios on the CML relying on the risk-return preferences.
However, the market portfolio and the CML are depicted without reference to
the risk-return tradeoff curves of the investors. This result is Tobins Separation
Theorem. It states that the best blend of risky assets in the market portfolio is
determined without considering the risk-return preferences of the investors.
Locating the best portfolio for a specific risk tolerance level consists of two
methods: finding the best blend of market securities that does not fluctuate
with risk tolerance and then joining it with a suitable amount of money.
History
In 1952, Harry Markowitz wrote his doctoral dissertation titled Portfolio Selection
that recognized the efficient frontier. In 1958, James Tobin included leverage to the
portfolio theory by including in the analysis an asset that pays a risk-free rate.
However, when combining a no-risk asset with a portfolio on the efficient frontier,
it is possible to assemble portfolios whose risk-return profiles are above those of
portfolios on the efficient frontier.
In 1964, William Sharpe developed the CAPM that exhibits assumptions; the
efficient portfolio has to be the market portfolio. Based on this, typical investors
must keep the market portfolio leveraged or deleveraged to realize their desired
risk.
Modern Portfolio Theory MPT
This theory was pioneered by Harry Markowitz in his paper "Portfolio Selection,"
published in 1952 by the Journal of Finance.
MPT shows that an investor can construct a portfolio of multiple assets that will
maximize returns for a given level of risk. Likewise, given a desired level of
expected return, an investor can construct a portfolio with the lowest possible risk.
Based on statistical measures such as variance and correlation, an individual
investment's return is less important than how the investment behaves in the
context of the entire portfolio.
MPT makes the assumption that investors are risk-averse, meaning they prefer a
less risky portfolio to a riskier one for a given level of return. This implies than an
investor will take on more risk only if he or she is expecting more reward.
Efficient Frontier
Every possible combination of assets that exists can be plotted on a graph, with the
portfolio's risk on the X-axis and the expected return on the Y-axis. This plot
reveals the most desirable portfolios. For example, assume Portfolio A has an
expected return of 8.5% and a standard deviation of 8%, and that Portfolio B has
an expected return of 8.5% and a standard deviation of 9.5%. Portfolio A would be
deemed more "efficient" because it has the same expected return but a lower risk.
It is possible to draw an upward sloping hyperbola to connect all of the most
efficient portfolios, and this is known as the efficient frontier. Investing in any
portfolio not on this curve is not desirable.