Very confusing SML vs CML question

CFA Level I Portfolio Management
#1

When comparing portfolios that plot on the security market line (SML) to those that plot on the capital market line (CML), a financial analyst would most accurately state that portfolios that lie on the SML:

A) have only systematic risk, while portfolios on the CML have both systematic and unsystematic risk. incorrect B**)are not necessarily well diversified, while portfolios on the CML are well diversified. CORRECT** C)are not necessarily priced at their equilibrium values, while portfolios on the CML are priced at their equilibrium values Although the risk measure on the capital market line diagram is total risk, all portfolios that lie on the CML are well diversified and have only systematic risk. This is because portfolios on the CML are all constructed from the risk-free asset and the (well-diversified) market portfolio. Any portfolio, including single securities, will plot along the SML in equilibrium. Their unsystematic risk can be significant, but it is not measured on the SML diagram because unsystematic risk is not related to expected return. Both the CML and the SML reflect relations that hold when prices are in equilibrium. I thought that if you lie on the SML you are well diversified… that you only have systemic risk… dont understand this question very well, althought I agree that portfolios on the CML are the best diversified because they hold “all risky assets”. But I dont get the SML response. Also, can someone please explain the C response, what does it mean priced at equilibrium values… thank you!!!

#2

Basically the SML represents the “market price” of the security / portfolio in question. This is because you use beta (covariance of asset and market over market variance, or in plain English, how risky the security is to the overall market) to determine the expected return relative to the long-term market return. All else equal, the security should always plot on the SML - which means when it doesn’t, it’s either 1)overvalued (expected return is below SML, so sell short) or 2) undervalued (expected return is above SML, so buy). In other words, this has nothing to do with diversification because you can’t diversify market risk (as measured by beta) so you can’t say that a security / portfolio on the SML is well diversified or not. Hope that helps…

#3

does the cml only have systematic risk or also firm specific? Same for sml
thx

#4

Any portfolio lies on CML should be both well diversified and efficient, because CML includes the market portfolio and the combinations between the market portfolio and the risk free asset.
Any security lies on the SML would be priced for its systematic risk only because the risk measurement in SML is just beta, which represents systematic risk. Any diversifiable risks will not be rewarded under SML. So, an undiversified security or portfolio may still get onto SML but simply its diversifiable risk will not be rewarded or priced in SML (i.e., CAPM model).
Hope this helps.