Importance of CML and SML while Taking Risks

Categories: Taking Risks

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CML stands for Capital Market Line, and SML stands for Security Market Line. The CML is a line that is used to show the rates of return, which depends on risk-free rates of return and levels of risk for a specific portfolio. SML, which is also called a Characteristic Line, is a graphical representation of the market’s risk and return at a given time. One of the differences between CML and SML, is how the risk factors are measured. While standard deviation is the measure of risk for CML, Beta coefficient determines the risk factors of the SML.

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The CML measures the risk through standard deviation, or through a total risk factor. On the other hand, the SML measures the risk through beta, which helps to find the security’s risk contribution for the portfolio.

While the Capital Market Line graphs define efficient portfolios, the Security Market Line graphs define both efficient and non-efficient portfolios. While calculating the returns, the expected return of the portfolio for CML is shown along the Y- axis.

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On the contrary, for SML, the return of the securities is shown along the Y-axis. The standard deviation of the portfolio is shown along the X-axis for CML, whereas, the Beta of security is shown along the X-axis for SML. Where the market portfolio and risk free assets are determined by the CML, all security factors are determined by the SML. Unlike the Capital Market Line, the Security Market Line shows the expected returns of individual assets.

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The CML determines the risk or return for efficient portfolios, and the SML demonstrates the risk or return for individual stocks. Well, the Capital Market Line is considered to be superior when measuring the risk factors.

Summary

The CML is a line that is used to show the rates of return, which depends on risk-free rates of return and levels of risk for a specific portfolio. SML, which is also called a Characteristic Line, is a graphical representation of the market’s risk and return at a given time.
While standard deviation is the measure of risk in CML, Beta coefficient determines the risk factors of the SML.
While the Capital Market Line graphs define efficient portfolios, the Security Market Line graphs define both efficient and non-efficient portfolios.
The Capital Market Line is considered to be superior when measuring the risk factors.
Where the market portfolio and risk free assets are determined by the CML, all security factors are determined by the SML.

Importance of CML and SML while Taking Risks. (2016, Apr 10). Retrieved from https://studymoose.com/importance-of-cml-and-sml-while-taking-risks-essay