What is the difference between Capital

market line and security market line?

Capital Market Line

A capital market line (CML) is a line intersecting returns on no-risk investments and returns on
the entire market. The difference between capital market line and efficient frontier, is that the
capital market line includes no-risk investments. All portfolios along the capital market line are
efficient portfolios.

Capital market line is used to evaluate portfolio performance. Any point below any other point
on the line will deliver lower returns but the same risk, and is therefore not ideal.

Capital market line is referred to as a measure employed to evaluate portfolio performance.

Capital market line or CML is a graph employed in asset pricing models to depict rates of return
in a market portfolio. Capital market line describes rates of return for efficient portfolios that are
dependent on level of risk and risk free rate of return for a specific portfolio. CML originates
from the assumption that all investors will possess market portfolio. Quantum of risk is
positively correlated to the expected return.

Thus, equation representing expected return is as follows:

Expected return = portfolio beta + risk-free rate

Capital market line is deduced by drawing a tangent line that starts from the intercept point
located on efficient frontier and extends to the point where expected return matches risk free rate
of return. Capital market line is believed to be a better measure than efficient frontier as it takes
into consideration risk-free asset in a portfolio. All points on the CML have better risk-return
profiles when compared to any portfolio located on efficient frontier.

Fig 1: Capital Market line

Security Market Line

The security market line (SML) is the graphical 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 (its beta).

The Y-intercept (beta=0) of the SML is equal to the risk-free interest rate. The slope of the SML
is equal to the market risk premium and reflects the risk return trade off at a given time:

The Security Market Line is a line intersecting the risk-free rate of return (represented as r sub f)
and the entire market (represented as M).

Returns are plotted on the y-axis, while risk (standard deviation, or sigma) is plotted on the x-
axis. The further to the right, the higher the risk. The further up, the higher the returns. Investors
need only asses their level of risk to find their optimal point on the line. That will tell them what
type of returns they can expect.
An investor can move up and to the right more (more risk, more returns) by borrowing money.

The Security Market Line is different than the efficient frontier in that the efficient frontier lacks
the risk-free rate of return point, and is therefore a curve.

Fig 2: Security Market line