Hi I’m struggling with this confusion over the relationship between the capital market line (CML) and security market line (SML). If the CML (or some variant of it based on relaxed assumptions) is the efficient frontier, would an asset that lies over the SML (undervalued) also implicitly lie over the CML? If not, why would anyone invest in the “undervalued” asset if some combination of risk-free bonds/market index (i.e some portfolio on the CML) offers a better risk adjusted return? Thanks
The CML is a combination of all risky assets called the market portfolio and the risk free asset in different proportions. The higher the proportion of market portfolio, the higher the risk and the higher the expected return. The SML assumes that there is no extra return that should be expected by holding a single security (with extra risk called unique risk) apart from the market risk that is not diversifiable. When the markets are in equilibrium the risk of a single security should match the market portfolio-risk free asset risk at a certain proportion with a given return. Keep in mind that each risk has an expected return attached to it. When the security has a return that is higher than expected return based on the underlying risk then the security is undervalued and will plot above the SML. Since the security provides a better risk adjusted return, then it is better to hold the stock.
Take notice that the CML uses Std Dev. in it’s calculations and the SML uses Beta. Std Dev measures market risk as well as company specific risk Beta only measures company specific risk The CML will show if a stock is over/under valued in relation to the market risk factors whereas the SML will show if the stock is over/under valued in relation to it’s company risk factors.
Thanks for your responses!