19.03.2023 - 20:12

Explain, and graphically depict, how Security Market Line (SML) is different from Capital Market Line (CML). Identify and discuss the importance of minimum variance portfolios. Why might the CAPM equa

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Explain, and graphically depict, how Security Market Line (SML) is different from Capital Market Line (CML). Identify and discuss the importance of minimum variance portfolios. Why might the CAPM equation be more relevant than other equations, when calculating required rate of return?

Answers (1)
  • EstLibre
    April 11, 2023 в 12:03

    The Capital Asset Pricing Model (CAPM) is a popular tool used in finance to estimate the expected return on an investment. The CAPM formula relates the expected return of a security to its beta, which measures its systematic risk compared to the market as a whole. The formula for the CAPM is:

    r = Rf + β(Rm - Rf)

    Where r is the expected return on the security, Rf is the risk-free rate of return, β is the security's beta, and Rm is the expected return of the market.

    The Security Market Line (SML) is a graphical representation of the CAPM formula. The SML plots the expected return of a security on the y-axis against its beta on the x-axis. The slope of the SML is the market risk premium (Rm - Rf), and the y-intercept is the risk-free rate (Rf).

    The Capital Market Line (CML) is another graphical representation of the relationship between risk and return. The CML plots the expected return of a portfolio on the y-axis against its standard deviation on the x-axis. The CML is formed by combining the risk-free asset with the market portfolio, which represents all the securities in the market in proportion to their market values. The CML is a straight line that starts at the risk-free rate and has a slope equal to the Sharpe ratio of the market portfolio.

    The key difference between the SML and the CML is that the SML focuses on individual securities, while the CML focuses on portfolios. The SML is used to determine whether a security is overpriced or underpriced based on its expected return and beta. The CML is used to identify the optimal portfolio of risky assets that maximizes the Sharpe ratio, which measures the excess return per unit of risk.

    Minimum variance portfolios are important because they represent the portfolio with the lowest possible risk for a given expected return. These portfolios lie on the efficient frontier, which is the set of portfolios that offer the highest expected return for a given level of risk or the lowest risk for a given expected return. Minimum variance portfolios are important for investors who are risk-averse and want to minimize their risk exposure.

    The CAPM equation is more relevant than other equations, such as the dividend discount model, when calculating the required rate of return because it takes into account the systematic risk of the security. Systematic risk is the risk that cannot be diversified away and is therefore an important factor in determining the expected return of a security. The CAPM equation is widely used in finance because it provides a simple and intuitive framework for estimating expected returns and for evaluating the risk and return of securities and portfolios.

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