CAPM vs CML

CFA Level I Portfolio Management
#1

All, I am still trying to understand the differences among CML, CAL and SML.

I believe that CAPM can be applied any security – diversified or non-diversified. But, its β will measure only systematic risk. On the other hand, CML can only be applied to diversified portfolios. Moreover, CML will tell us total risk, not just systematic risk. Moreover, CAL can be applied to any portfolio. And it will give me a relationship between total risk and expected returns. Am I right? This thing is really troubling and confusing me. I believe CFAI material hasn’t done justice to this topic.

I would appreciate any thoughts.

Thanks in advance.

#2

CAL:

Is the line that shows a Risk free asset and any risky asset porfolio.

CML:

Is like the CAL, the difference here is that the CML uses the market portfolio as the risky asset. (optimal risky portfolio)

Both CML & CAL can be used for efficient Portfolios. They both use Standard deviation of portfolio as the X- Axis. (= Total risk)

SML:

This is CAPM.

This can be applied to any security, therefore you may use inefficient portfolios (unlike cml & cal). Beta is your x axis (not total risk)

Why does CML & CAL use total risk & SML use Beta and how does this relate to effiienct portfolios?

CAL & CML use total risk, which = systematic + unsystematic. Therefore since only systematic is priced, they can only be used for efficient porfollios.

The SML uses only Beta = Systematic risk, therefore any security can be used regardless of its effiency.

Hope that makes some sense, it confuses me too!

#3

Maybe this article will help a bit: http://financialexamhelp123.com/cal-vs-cml-vs-sml/.

#4

Hello S2000magician,

Thank you for your response. I did read your excellent blog. However, I still have a few questions, if you could clarify:

#1 – CAPM can be applied any security – diversified or non-diversified. However, it will only measure systematic risk. (β =systematic risk.)

#2 CML can be applied only to efficient (diversified) portfolios. CML will use total risk (i.e. systematic + unsystematic risk).

#3 - CAL can be applied to any (i.e. efficient or inefficient) portfolio. It uses total risk.

I believe the poster above has echoed similar viewpoints, but I thought of confirming with you before registering this in my head permanently.

I would appreciate your help.

Thanks in advance.

#5

why capital market line has the highest slope /sharp ratio?

#6

Correct.

Because the CML uses total risk as the x-axis, it’s appropriate for all portfolios. Of course, we expect that only efficient portfolios will plot on the CML and other portfolios will plot below it. (Ex post, some portfolios may plot above it.)

Correct. Note that there are numerous CALs.

#7

It’s by definition - the CML is defined as the capital allocation line that combines the risk-free asset with the portfolio on the efficient frontier that has the highest sharpe ratio - in other words, the line with the highest slope that you could draw from the RF asset to a possible risky portfolio. Visually this would be the line that’s tangent to the efficient frontier.

So, since the CML consists of linear combinations (i.e combinations where the weights add up to 100%) of the RF asset and this “best” portfolio, the portfolio will have higher sharpe ratios than the portfolios on any other line.

#8

thanks for explanation.

#9

“CAL & CML use total risk, which = systematic + unsystematic. Therefore since only systematic is priced, they can only be used for efficient porfollios.”

@rexthedog

Can you please shed some more light on it?