## Capital Market Line (CML) and Security Market Live (SML)

Meaning and Their Difference

Unit 3 SAPM Notes

**Capital Market Line (CML) Meaning**

Capital Market Line (CML) is a line used in the capital asset pricing model to illustrate the rates of return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio.

The CML is derived by drawing a tangent line from the intercept
point on the efficient frontier to the point where the expected return equals
the risk-free rate of return. The CML is considered to be superior to the
efficient frontier since it takes into account the inclusion of a risk-free
asset in the portfolio.

The CML is the relationship between the risk and the expected
return for portfolio. The CML results from the combination of the market
portfolio and the risk-free asset. All points along the CML have superior
risk-return profiles to any portfolio on the efficient frontier, with the
exception of the Market Portfolio, the point on the efficient frontier to which
the CML is the tangent. From a CML perspective, this portfolio is composed
entirely of the risky asset, the market, and has no holding of the risk free
asset ,i.e., money is neither invested in, nor borrowed from the money market
account.

**Security market line (SML) Meaning**

Security market line (SML) is the representation of the Capital
asset pricing model. It displays the expected rate of return of an individual
security as a function of systematic, non-diversifiable risk (its beta). It is
also referred to as the "characteristic line".

The SML essentially graphs the results from the capital asset
pricing model (CAPM) formula. The x-axis represents the risk (beta), and the
y-axis represents the expected return. The market risk premium is determined
from the slope of the SML. The security market line is a useful tool in
determining whether an asset being considered for a portfolio offers a
reasonable expected return for risk. Individual securities are plotted on the
SML graph. If the security's risk versus expected return is plotted above the
SML, it is undervalued because the investor can expect a greater return for the
inherent risk. A security plotted below the SML is overvalued because the
investor would be accepting less return for the amount of risk assumed.

**Difference
between Capital Market Line and Security Market Line**

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 market’s risk and return at a given time.

2. While standard deviation is the measure of risk in CML, Beta
coefficient determines the risk factors of the SML.

3. While the Capital Market Line graphs define efficient
portfolios, the Security Market Line graphs define both efficient and
non-efficient portfolios.

4. The CML determines the risk or return for efficient portfolios,
and the SML demonstrates the risk or return for individual stocks.

5. Where the market portfolio and risk free assets are determined
by the CML, all security factors are determined by the SML.

6. 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.

7. 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.

8. Finally, the Capital Market Line is considered to be superior
when measuring the risk factors.