CML vs SML

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.

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. 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.
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:
1. 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.

2. While standard deviation is the measure of risk in CML, Beta coefficient determines the risk factors of the
SML.

3. While the Capital Market Line graphs define efficient portfolios, the Security Market Line graphs define
both efficient and non-efficient portfolios.

4. The Capital Market Line is considered to be superior when measuring the risk factors.

5. Where the market portfolio and risk free assets are determined by the CML, all security factors are
determined by the SML.

Security market line (SML) is a graph that plots the required return on investments with reference to its beta
coefficient, a measure of systematic risk. Security market line represents the capital asset pricing model
which measures required returns as equal to the risk-free rate plus the product of beta coefficient and market
risk premium.

The security market line differs from the capital market line (CML) which plots the required return on a
portfolio of risk-free asset and the market portfolio with reference to the portfolio’s standard deviation.
Capital market line (CML) in turn is a special case of the capital allocation line (CAL). Capital allocation
line is the graph of a portfolio of risk-free asset and ANY portfolio of risky assets while the capital market
line is the graph of the capital allocation line that is tangent to the efficient frontier.
Stocks that are plotted above the security market line are undervalued. It is because they have higher
required return than the required return justified by the capital asset pricing model. Similarly, stocks that fall
below the security market line are overvalued because they have lower required return than the fair-value
return suggested by the capital asset pricing model and hence high stock price.

Formula

The following equation is the mathematical express of the security market line:

Where re is the required return on an asset, rf is the risk-free rate, β is the beta coefficient which measures
the extent to which a stock’s return must change in response to a change in systematic risk.

Example

If the risk-free rate is 3.5% and the equity risk premium is 5%, find out if the below investments are
overvalued or undervalued given their beta coefficient and required rate of return observed using the
dividend discount model:

Using the capital asset pricing model equation (which is also the equation for the security market line), we
can work out the justified required rate of return on each stock as follows:
If we plot the justified required rate of return and the required rate of return observed in the market i.e. the
required return extracted from the current price using the dividend discount model, we can see whether they
fall on the security market line.

Security Market Line

Stock B and D are overvalued because their observed required returns (as per DDM) are higher than the
justified required returns (as per CAPM) and they appear above the security market line.

Stock A and C are overvalued because their observed required returns are lower than required returns that
should prevail given their systematic risk. They appear below the security market line.
Only Stock E is fairly-valued because it appears on the security market line. It is because its observed
required return and CAPM required return are same.

Security Market Line

What do we mean by Security Market Line?

The Capital Asset Pricing Model is graphically represented by drawing the Security Market Line. It shows
the amount of returns an investor can expect from the market with regard to the different levels of market or
systematic risk. These risks are those whose elimination is further not possible by diversification. In other
words, it depicts the relationship between the risks of a security, measurable by its beta coefficient, and the
returns that one can expect from it at every level of risk.

The concept of the Security Market Line is very popular for portfolio management. It helps to derive the
pricing of risky securities by plotting their expected returns. It takes into account the risk that comes along
with such investments, as well as the cost of capital. Also, it represents the opportunity cost of an investment
and guides an investor to compare an investment opportunity at market risk with a risk-free investment.

Table of Contents

1. What do we mean by Security Market Line?

2. Equation for Security Market Line
3. Main Components of the Security Market Line
1. Beta
2. The Risk-free Rate of Return and Systematic Risk
3. Expected Market Return
4. Time Value of Money
4. Interpretation of the Security Market Line
5. Example of a Security Market Line
6. Advantages and Disadvantages of the Security Market Line
1. Advantages of SML:
2. Disadvantages of SML:
The other name for Security Market Line is the “characteristic line”. While graphically representing this
line, we plot the beta or the asset risk on the x-axis. The plotting of the return an investor expects from a
security is done on the y-axis.

Equation for Security Market Line

The Security Market Line basically represents the prevailing risk-free return and the beta coefficient of the
security. The formula to calculate the expected return and plotting the Security Market Line is:

SML= Risk-free rate of return + Beta coefficient (Market rate of return – Risk-free rate of return)

Main Components of the Security Market Line

Let us go through the main components of the above equation in detail.

Beta

Beta or Beta coefficient is one of the most important components for using the Security Market Line. It is a
numerical value and is a measure of how a stock or security will move when the entire market goes up or
down. It measures the systematic risk or the non-diversifiable risk of an asset with regard to the market
portfolio.

The overall market average of risk is assumed to be beta value 1. A security with a high correlation to the
market will have a beta coefficient greater than one. Such securities fall in the category of being highly
risky. On the other hand, a security with a beta coefficient of less than one has a low correlation to the
market and is less volatile or less risky.

The above discussion is from a risk perspective. However, the universal law is that the higher the risk, the
higher can be the return also. Therefore, securities having a beta coefficient of more than 1 or of course
highly risky but in times of upward market trend, they are the ones that will fetch you more returns than the
market indices. So higher volatility gives an edge in a rising market.

Suppose a security has a beta coefficient of 1.5. It will mean that it is 50% more risky or volatile than the
average of the market. However, if the market goes up by 20%, such a security should go up by 1.5 x 20=
30%.

The Risk-free Rate of Return and Systematic Risk

A risk-free rate of return is the return that an investor will get with any security or investment with near-zero
risk over a time period. Thus, it is the least an investor will get as a return from his investment. An investor
will go for a riskier investment only if he gets a return that is higher than the risk-free rate of return. Or in
other words that is the extra premium or return that attracts him to take extra risk.

This rate is just theoretical and does not actually exist as an option for an investor because every investment
comes with some amount of risk. The calculation for this rate is simply done by taking the yield of the
Treasury bond and adjusting or subtracting the current inflation rate.    

Systematic risk is the risk of operating in the market and that is the same and applicable to all the
participants of the market. Diversification of investments does not eliminate this risk. Factors that cause
such a risk can be economic and policy changes, interest rates, political disturbances, natural calamities, etc.

Expected Market Return

It is the rate of return available in the present scenario for various types of securities under consideration. In
this exercise, we have the expected rate of return for all the available securities. This we compare with the
risk-free return. And thereafter according to the gap/difference in the returns, the beta calculation, and
ranking happens. Then finally based on the risk appetite and portfolio composition the securities for
investment purpose is identified.

Time Value of Money

This concept means that an amount of money in hand is more worthy than the same sum of money at some
future date. This is so because money has the potential to grow, either by investing it in some business
activity, the stock market, or simply by depositing it with a bank and earn interest on it.

Thus, a prudent investor will want returns from his investment because of the risk he undertakes on his
investment. His money has an opportunity cost- he can invest it in other avenues other than the current
security investment option and still generate returns. Moreover, he will want higher returns on his
investment from securities with a high beta because of the higher risk he will bear than the market average.

Interpretation of the Security Market Line

In the field of finance, the Security Market Line has a slope when we present it graphically. An investor
looks for extra returns to offset the extra risk he will be taking by investing in a particular security. Hence,
the difference between the risk-free return available in the market and the expected return of the investor
from such a risky security is named as the market risk premium. This market risk premium guides the slope
of the SML. The slope will be steep with a high market risk premium, and gradually it will decrease as the
market risk premium goes down. A zero beta security or a security with nil market risk premium has the
risk-free rate as its expected rate of return.

The Security Market Line can reflect the correct pricing of an asset. It helps to ascertain whether a security
is overpriced or under-priced and thus, is crucial for making prudent investment decisions. An asset will be
under-priced or undervalued if it appears above the SML in the graph. It is so because it is giving a higher
return than the market at a given level of systematic risk. Similarly, an asset will be overpriced or
overvalued if it appears below the SML. The logic is the same- it is giving a return lower than the market at
a particular level of systematic risk.

Example of a Security Market Line

Let us assume that the risk-free rate is 4%, and the market returns that an investor should expect is 15%. We
have two securities in hand: A with a beta of 0.6 and B with a beta of 1.8.

Now let us calculate the expected market return from both the securities by using the SML equation.

Expected return for Security A: 4 + 0.6 (15-4)

= 4 + 0.6(11)

= 10.6%

Expected return for Security B: 4 + 1.8(15-4)

=4 + 1.8(11)

=23.8%

Thus security B has higher expected returns because it has a higher beta and hence, is riskier than security
A.

Advantages and Disadvantages of the Security Market Line

The SML like any other indicator has certain advantages and certain disadvantages as well. Let us
understand first the advantages it offers:

Advantages of SML:

 The SML model along with the CAPM is very easy to use and easily comprehendible. It plays a
major role in portfolio planning and management. It helps an investor or a portfolio manager to make
rational investment decisions by charting the expected returns from securities and asset classes.
  The model does not ignore systematic risk or market risk while giving the expected returns. This is
important and helpful as such risk comes along with every investment opportunity and cannot be
done away with.

Disadvantages of SML:

 The SML and CAPM models use the risk-free rate as their basis for calculations. This rate can
change, causing volatility and unpredictability in the results of the model.
 The market returns an investor uses for calculations come from past results that are not certain to be
the same in the current times or future. Also, they can be negative in the short term and change over
time, causing the results to be unreliable.
 Factors such as inflation or deflation, economic and political changes, or other macroeconomic
factors such as unemployment can cause the slope of the SML to change or shift with time. Hence,
the results will keep changing and not be constant.
 The basis for calculations in this model is the beta coefficient an investor decides to take for his
security. The results from the use of this model will go wrong if the calculation of beta is wrong or it
changes with time.