Question

1.1. In the context of the CAPM, explain the difference between the SML and the CML (3).

1.2. The market portfolio has an expected return of 0.12 and a standard deviation of 0.40, and the risk-free rate is 0.04. Calculate the slope of the security market (2).

1.3. Explain what the slope of the SML represents (3).

Answer 1

1.1

Answer: The CML and SML both show trade off between risk and expected return. The difference between the two is CML measure the risk by standard deviation which consist systematic and unsystematic risk whereas SML only takes systematic risk into consideration.

1.2

Answer :  Slope of SML=Expected return of market minus risk-free rate of return

Slope = 0.12 - 0.04 = 0.08

1.3

Security market line (SML)

The security market line (SML) is the graphical representation of the Capital Asset Pricing Model (CAPM) and gives the expected return of the market at different levels of systematic or market risk. It is also called ‘characteristic line’ where the x-axis represents beta or the risk of the assets, and the y-axis represents the expected return.

Security Market Line Equation

The Equation is as follows:

SML: E(R_i) = R_f + β_i [E(R_M) – R_f]

In the above security market line formula:

• E(R_i) is the expected return on the security
• R_f is the risk-free rate and represents the y-intercept of the SML
• β_i is a non-diversifiable or systematic risk. It is the most crucial factor in SML. We will discuss this in detail in this article.
• E(R_M) is expected to return on market portfolio M.
• E(R_M) – R_f  is known as Market Risk Premium

The above equation can be graphically represented as below: