I have a quesiton regards to CML and SML. in schweser’s book, it says the tengency portfolio at CML and efficient front tier is the market portfolio, and we all know market portfolio has beta of 1. also, the slope of SML is beta as well. from my undestanding, if a security is properly priced, it lays on SML. But there’s a sentence says “if markets are in equilibrium, risk and return combinations for individual securities will lie along the SML, but not along the CML” i don’t get it, how does this make sense? if a secuirty lays on SML, that means this security has beta of 1, which is the same as the beta of 1 for market portfolio. can someone explain?
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I have a quesiton regards to CML and SML. in schweser’s book, it says the tengency portfolio at CML and efficient front tier is the market portfolio, and we all know market portfolio has beta of 1. also, the slope of SML is beta as well.
No, the slope of the SML is the market risk premium: E(RM) – rf.
Because beta measures only the systematic risk of the security, whereas standard deviation of returns measures the total risk – systematic and unsystematic – of the security. Because the total risk (of an individual security) will exceed the systematic risk, the point will lie to the right of – below – the CML.
It doesn’t mean that at all. The horizontal axis in the SML plot is β, which can run from –∞ to +∞ (conceivably). A fairly-priced security that has β = 0.5 will lie on the SML, half-way between the risk-free asset and the market portfolio. A fairly-priced security that has β = 1.5 will lie on the SML, above and to the right of the market portfolio, and so on. But if these securities have systematic risk, they will lie below the CML because their standard deviation of returns will be higher than the standard deviation of returns for a well-diversified portfolio – with systematic risk but no unsystematic risk – having the same expected return.
still somewhat confused, there’s a quesiton in Schewser’s book(self-test:portfolio management), it gives you a portfolio Y lies on CML and efficient frontier, so this profilio is the market profolio. In the question it also states “all assets are priced at their equilibrium levels consistent with the CAPM.” so there’s an asset - Asset A, is plotted to the right of the portfolio Y with the same expected return. In the answer section it says “since Asset A has the same expected return as Portfolio Y, it must have the same beta as the market portfolio, which is one”, in this case, if Asset A has the same expected return, you can assume it has the same beta as market?
I wish i can post the graphes here so it would make more sense…not sure if you can picture it…
on which page is the question? I have the schewser notes too but couldn’t find the chart you were referencing too or question.
Book 5, page 243, question 2
First of all, it is plotted to the right exactly because its total risk (as measured by σ) is greater than the market porfolio’s risk. That makes sense because there is no diversification benefit by holding just the asset A. By holding just A, we might be earning a return as high as the market’s, but we are taking on more risk.
Now, assuming that Asset A is fairly priced (i.e. in equilibrium), it follows that the only instance where its return is equal to that of the market portfolio’s is the case where its systematic risk (b) is 1.
To see why, just play around with the E® = RFR + b*[(E(Rm) - RFR)] formula. Do notice that the security’s expected return E® is not a function of its own risk. This is an expression that tells us how much the security should be priced given a specific Market return, risk free rate and beta.
Now, assume that the markert porfolio is e.g. E(Rm) = 10% and the Risk free rate is RFR =5%,
There is, by virtue of algebra, only one way where E® = 10%. That is when b = 1. ( E® = 5 + 1*(10 - 5) ). Once again. if the security is in equilibrium and the Expected return is equal to the market, then it has to be the case that b = 1.
Wow…thank you both. I’m taking a screenshot of your posts