CAPM/SML vs CML

CFA Level I
#1

Hi,

  1. According to Schweser, CAPM states that the expected return on all portfolios, well diversified or not, are determined by their systematic risk only. But isn’t systematic risk defined as the contribution of a security’s risk to a well-diversified portfolio? So doesn’t CAPM state that we NEED to have a well-diversified portfolio?

  2. Schweser also says that systematic risk can apply to portfolios as well. How is that possible given the above definition?

  3. CML plots efficient portfolios (i.e. highest return per unit of total risk). Why doesn’t the SML do the same? Is it because the market only compensates people for bearing systematic risk and thus the SML only plots properly priced securities? Instead of focusing on total risk like the CML (i.e. looking at efficient portfolios), the SML plots expected returns for securities based on the only source of risk that should be priced in (systematic risk)?

#2

Responding to your queries

  1. CAPM assumes that an investor will diversify and have no unsystematic risk. Therefore it assumes systematic risk is the only risk assumed by CAPM which is the security’s only risk exposure to a well-diversified portfolio.

  2. So a security has two risks 1) systematic 2) unsystematic (diversifiable)

  3. CML gives relationship between Return and Total Risk (Systematic + Unsystematic)

Whereas SML graphs the CAPM relationship between Return and Systematic Risk, where all unsystematic risk is diversified out

These are essentially two theories with different assumptions.