Could somone please explain the key differences between the Capital Market Line and the Security Market Line?
CML is a line that plots the return vs risk for a specific porfolio.SML is a line that plots the risk vs return for the market at a given time. A few differences are discussed below
- CML uses standard deviation as the measure of risk
- SML uses beta as the measure of risk
Efficient and Non-efficient
- CML graph defines efficient portfolio
- SML graph defines both efficient and non-efficient portfolios
Portfolio Vs Stock
- CML determines risk or return for efficient portfolios
- SML determines risk or return for individual stock
CAL plots portfolio returns against total risk (systematic and unsystematic). Since it uses total risk, it is useful for efficient portfolios ONLY i.e. portfolios that have zero unsystematic risk, hence total risk equals systematic risk, Beta. CML is a special case of the CAL where the efficient portfolio is the market portfolio.
SML on the other hand plots returns against systematic risk (Beta) ONLY. Since it is based on Beta only, it can be applied to individual stocks as well as portfolios (whether efficient or not). The SML is the graph of the CAPM equation. The slope of the SML equals the market risk premium.
Sharpe is the slope of the CML
Jensen’s alpha is based on SML