Capital Market Line

‡ Rational Investors will choose a combination of risky and risk-free assets. ‡ 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.

‡ CML originates from the assumption that all investors will possess market portfolio.CML (contd) ‡ CML is a graph employed in asset pricing models to depict rates of return in a market portfolio. Quantum of risk is positively correlated to the expected return. ‡ The equation representing expected return is as follows: Expected return= portfolio beta + risk-free rate . ‡ 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 is believed to be a better measure than efficient frontier as it takes into consideration risk-free asset in a portfolio.CML (Contd) ‡ 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. All points on the CML have better risk-return profiles when compared to any portfolio located on efficient frontier .

CML (Graph) .

Security Market Line ‡ In efficient portfolios there is a linear relationship between the expected return and standard deviation ‡ The expected return and standard deviation of inefficient portfolios will be below the CML line. . and the y-axis represents the expected return. ‡ A line that graphs the systematic/ market. The x-axis represents the risk (beta). ‡ The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. risk versus return of the whole market at a certain time and shows all risky marketable securities. The market risk premium is determined from the slope of the SML.


± Here the securities A & B's risk versus expected return is plotted above the SML. ± The securities C & D are plotted below the SML and so it is overvalued as the returns are lower for the amount of risk assumed.SML (CONTD) ‡ The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for risk. it is undervalued as the investor can expect a greater return for the inherent risk. . ‡ Individual securities are plotted on the SML graph.

‡ Mr.Arbitrage Pricing Theory (APT) ‡ CAPM model came under criticism. such returns differentials should not exists. ‡ Empirical studies showed that ± Low P/E stocks underperformed high P/E stocks ± Small cap stocks outperformed large cap stocks on a risk-adjusted basis ± Value stock generated higher returns than growth stocks ‡ In theory: in efficient market. Stephen Ross developed an alternative model called Arbitrage Pricing thoery (APT) .

APT (Contd) ‡ In this theory a number of risks can be considered. ‡ APT predicts a relationship between the returns of a portfolio and the returns of a single asset through a linear combination of many independent macroeconomic variables. ‡ A mis-priced security will have a price that differs from the theoretical price predicted by the model . ‡ Arbitrageurs use the APT model to profit by taking advantage of mis-priced securities.

Ri = ai + i(m) Rm + i(1)F1 + i(2)F2 + + i(N)FN + ei Ri is the returns of security i Rm is the market return F(1.2. ‡ The multi-factor model can be used to explain either an individual security or a portfolio of securities. ‡ It will do this by comparing two or more factors to analyze relationships between variables and the security s resulting performance.3 N) is each of the factors used is the beta with respect to each factor including the market (m) e is the error term a is the intercept .Multi-Factor Model ‡ A financial model that employs multiple factors in its computations to explain market phenomena and/or equilibrium asset prices.

‡ Statistical models are used to compare the returns of different securities based on the statistical performance of each security in and of itself. ‡ Fundamental models analysis the relationship between a security's return and its underlying financials (such as earnings). such as risk.Multi-Factor Model ‡ Multi-factor models are used to construct portfolios with certain characteristics. When constructing a multi-factor model. or to track indexes. fundamental and statistical models. it is difficult to decide how many and which factors to include. . inflation and interest. ‡ Multi-factor models can be divided into three categories: macroeconomic. ‡ Macroeconomic models compare a security s return to such factors as employment.

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