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Difference Between SML and CML?
By Bajaj Broking Team
October 18, 2023
5 mins read
Share Market
ENGLISH
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Various analytical tools are available for investors to assess and understand stocks and trends of the share market. These tools offer valuable guidance to the investors who can utilise them to broaden their investment vision, limit the scope of risk, and increase the potential for profit. The Security Market Line and the Capital Market Line are two such valuable tools that you can use to limit the scope of risk associated with your investments. Read on to know in detail about the meaning of SML and CML and understand the major differences between the two market lines.
What is the Capital Market Line (CML)?
The capital market line (CML) is a graphical representation that shows you the relationship between the risks and returns of different portfolios. It links the risk-free rate of return with a portfolio composed of risky assets. Unlike the SML, which focuses solely on individual assets, the CML incorporates the concept of diversification by combining a risk-free asset with a portfolio of risky assets. The risk-free asset is typically represented by government bonds, which are considered to have negligible default risk.
In simpler terms, the CML showcases the optimal portfolios that blend the risk-free asset with a diversified mix of risky assets. These optimal portfolios offer the highest return for each level of risk, thus enabling you to customise your portfolios according to your risk preferences.
The CML offers a visual representation of the risk-return tradeoff that you face when you are constructing a portfolio consisting of different assets. It highlights the benefits of diversification and the potential to enhance returns without incurring excessive risk. The slope of the CML, known as the Sharpe ratio, quantifies the incremental return per unit of risk in the portfolio. So, the CML serves as a guide for building portfolios that balance the goal of earning higher returns with prudent risk management.
What is the Security Market Line (SML)?
The security market line (SML), much like the CML, is a graphical representation of the risk and expected returns of an asset. Unlike the CML, the SML focuses solely on individual assets rather than complete portfolios. It plots the relationship between an asset’s expected return and its systematic risk, which is measured by its beta. The beta captures an asset’s sensitivity to market movements and serves as a gauge for its systematic risk.
The SML is derived from the Capital Asset Pricing Model (CAPM), which asserts that an asset’s expected return should be proportional to its beta. Mathematically, the SML is represented as follows:
E(Ri) = Rf + βi [E(Rm) — Rf]
Here, the parameters used in the above equation mean the following:
E(Ri) is the expected rate of return from the stock or asset
Rf is the risk-free rate of return, i.e. the theoretical rate of return that carries zero risk
βi is the systematic risk of the stock or asset
E(Rm) is the expected rate of return from the market as a whole
E(Rm) — Rf is known as the risk premium
What Does the Security Market Line Tell You?
The SML plays a critical role in assessing an asset’s valuation based on its risk. If an asset lies above the SML, it is considered undervalued, as it offers higher returns than its systematic risk justifies. Conversely, assets below the SML are overvalued, indicating that their expected returns do not adequately compensate for their risk.
Even though both the SML and the CML are market lines that compare risks and returns, here are the key differences between the CML and SML.
Scope of the Market Line
The capital market line focuses on portfolios that consist of a mix of risky and risk-free assets. But the security market line only concentrates on individual assets like stocks.
Components of the Market Line
The capital market line combines a risk-free asset with a portfolio of risky assets. But the security market line correlates an asset’s expected return to its systematic risk or beta.
Applicability of the Market Line
If you are interested in constructing a diversified portfolio that optimises the risk-return tradeoff, the capital market line will be useful. But if you want to assess the valuation of individual assets based on their risk, the security market line is more suitable.
Let us tabulate the key differences between the CML and SML.
Particulars
Security Market Line
Capital Market Line
Area of focus
Individual assets
Portfolios of risky as well as risk-free assets
Parameters used
Systematic risk i.e. beta
Diversification and risk-free rate
Primary application
Asset valuation and selection
Portfolio optimisation
Equation
E(Ri) = Rf + βi [E(Rm) — Rf]
E(Rp) = Rf + [{E(Rm) — Rf} ÷ σm] x σp
Risk-return tradeoff
Evaluates the risk-return tradeoff for a single asset
Helps build efficient portfolios with varying levels of risk
Security Market Line vs Capital Market Line: Which Should You Use?
Determining which indicator to use between the SML and the CML depends on your specific investment objectives and needs. If you are focused on analysing individual assets and their valuation based on risk, the SML is your tool of choice. On the other hand, if you aim to construct a diversified portfolio that optimises the risk-return tradeoff, the CML provides a comprehensive framework.
In essence, both the SML and the CML serve distinct yet complementary purposes. The SML guides asset selection and valuation, while the CML facilitates the creation of well-balanced portfolios. As an investor, your choice between the two should align with your investment goals and the level of risk you are willing to undertake.
In conclusion, grasping the disparities between SML and CML provides investors with valuable insights into risk assessment and portfolio management. While SML focuses on individual securities and their relationship with market risk, CML provides a broader perspective by incorporating the entire market portfolio. By understanding these concepts, investors can make more informed decisions tailored to their risk tolerance and investment objectives. To embark on your investment journey with precision and convenience, download the Bajaj Broking app today and leverage its powerful tools for seamless trading and investing experiences.
The Capital Market Line (CML) represents the risk-return trade-off for efficient portfolios in the capital market. It shows the expected return of a portfolio based on its risk, measured by standard deviation.
What is SML?
Answer Field
The SML illustrates the relationship between an asset’s expected return and its beta, reflecting the risk-return trade-off for individual securities. It is a key component of the Capital Asset Pricing Model (CAPM).
What is SML full form?
Answer Field
The full form of SML is Security Market Line, which graphically represents the expected return of an investment relative to its systematic risk, as defined by the CAPM.
What is the main difference between SML & CML?
Answer Field
The SML represents the risk-return profile of individual securities based on their beta, while the CML represents the risk-return profile of efficient portfolios based on total risk.
What is the difference between SML and CAPM?
Answer Field
SML is a graphical representation of the Capital Asset Pricing Model (CAPM), showing expected returns relative to beta. CAPM is the broader model that includes SML as a tool for evaluating individual securities.
What is the difference between CML and CAPM?
Answer Field
The CML is part of the CAPM framework, showing the risk-return trade-off for efficient portfolios. CAPM is a broader model that includes both the CML for portfolios and the SML for individual securities.