Can someone please clarify the differences between the security market line and the capital market line. Thanks
Capital market line is a line on a graph where x-axis is risk and y-axis is expected return. At zero risk, the expected return is the risk-free rate. Any non-zero risk better offer a higher return, or else that would be a foolish investment. So on this set of axes, you can draw the ‘efficient frontier’ which marks the best portfolios one can build offering best return for a given level of risk. The Capital market line itself connects the point at the risk-free-rate (zero risk) to a point tangent to the efficient frontier. Along this line, using a combination of the efficient portfolio and risk-free investments, is the most optimal investment. Security market line is on a different graph, x-axis is Beta, and y-axis is expected return. At zero beta (zero correlation w/ the market portfolio) is the risk-free rate, and at beta=1 is the market portfolio with a higher expected rate of return. Connecting these points is the Security market line. SML indicates what the expected return of a security should be given its Beta, where Beta is covariance of a security divided by the variance of the market portfolio.
to complete stratus from my understanding CML is the best combination ( max return for risk taken) of different proportions of RFR and the Market Portfolio.the extremes are RFR - 100% , point M-100% market portfolio.From RFR to point M - you have a portion in market portfolio and a portion in RFR. if you pass point M on the curve that means that you would borrow money at RFR to invest in market portfolio achieving financial leverage For SML - the curve of expected return given an amount of risk taken- basically the order of investments from the safest to the riskiest that is my understanding
Only efficient portfolios will lie on the CML, only fairly priced securities lie on the SML.