A line used in the capital asset pricing model to
illustrate the rates of return for efficient portfolios depending on the
risk-free rate of return and the level of risk (standard deviation) for a
particular portfolio.
The CML is derived by drawing a tangent line from
the intercept point on the efficient frontier to the point where the expected
return equals the risk-free rate of return.
The CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk-free asset in the portfolio. The capital asset pricing model (CAPM) demonstrates that the market portfolio is essentially the efficient frontier. This is achieved visually through the security market line (SML).
The CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk-free asset in the portfolio. The capital asset pricing model (CAPM) demonstrates that the market portfolio is essentially the efficient frontier. This is achieved visually through the security market line (SML).
Security market line (SML) is the
representation of the capital asset pricing model. It displays the expected
rate of return of an individual security as a function of systematic, non-diversifiable
risk .
When used in portfolio management, the SML
represents the investment's opportunity cost (investing in a combination of the
market portfolio and the risk-free asset). All the correctly priced securities
are plotted on the SML. The assets above the line are undervalued because for a
given amount of risk (beta), they yield a higher return. The assets below the
line are overvalued because for a given amount of risk, they yield a lower
return.
There is a question about what the SML looks like
when beta is negative. A rational investor will accept these assets even though
they yield sub-risk-free returns, because they will provide "recession
insurance" as part of a well-diversified portfolio. Therefore, the SML
continues in a straight line whether beta is positive or negative. A different
way of thinking about this is that the absolute value of beta represents the
amount of risk associated with the asset, while the sign explains when the risk
occurs.
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