statement :- Portfolios that are not on CML are not efficient and will not be rewarded by the market for additional risk in equillibrium.
Problem :- shouldnt the market in equillibrium adjust the prices of these securities such that the prices of hte securities lower and hence their expected returns increase and hence these securities too end up lying on the CML in equillibrium?
Can someone clarify?
Key word is in equilibrium. CML takes into account total risk. According to capital market theory, you are not rewarded for unsystemic risk because diversification is free.
Total risk = Systemic risk + Unsystemic risk
So although you may get better returns in isolated securities than the market, in equilibrium, you will only be rewarded for systemic risk. Systemic risk for some securities may be much lower than unsystemic risk.
Yes, the market will adjust the price of the security, but only as it relates to systemic risk because all properly priced securities will lie on the SML. The CML, however, will take the unsystemic portion into account and move it away from the CML ot the right.