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.
If your entire portfolio is now composed of stock A and you can add some of only onestock to your
portfolio, would you choose (explain your choice):
Choose D since it has the lowest correlation with A and will reduce the portfolio’s risk by
the greatest amount. Note that since all stocks have the same E(r), adding any of the other stocks
will not change the portfolio’s E(r).

18.Would the answer to Problem 17 change for more risk-averse or risk-tolerantinvestors? Explain.
No, risk aversion is not a factor when choosing between risky assets. For all levels of
riskaversion, lower risk is better.

Extra Question: What if A = 0?

What if A = 0? This would be a “risk -neutral” investor. Risk neutral investors would not care
which portfolio they held since all portfolios have an expected return of 8% and utility is not
affected by risk.

Extra Question: What if A< 0?

If A < 0 then utility is increasing in risk . The person is called a “risk lover.”In this case, a
person would prefer adding no assets, since adding any asset that is not perfectly positively
correlated reduces risk. But if forced to add an asset, B would be preferred since it would reduce
risk the least

CHAPTER 6 Capital Allocation to Risky Assets

For Challenge Problems 27, 28, and 29: You estimate that a passive portfolio, that is, one
invested in a risky portfolio that mimics the S&P 500 stock index, yields an expected rate of
return of 13% with a standard deviation of 25%. You manage an active portfolio with
expected return 18% and standard deviation 28%. The risk-free rate is 8%.
27. Draw the CML and your funds’ CAL on an expected return–standard deviation diagram.
a. What is the slope of the CML?
b. Characterize in one short paragraph the advantage of your fund over the passive fund.
28. Your client ponders whether to switch the 70% that is invested in your fund to the passive
portfolio.
a. Explain to your client the disadvantage of the switch.
b. Show him the maximum fee you could charge (as a percentage of the investment in your
fund, deducted at the end of the year) that would leave him at least as well off investing in
your fund as in the passive one. ( Hint: The fee will lower the slope of his CAL by reducing
the expected return net of the fee.)
29. Consider again the client in Problem 19 with A 5 3.5.
a. If he chose to invest in the passive portfolio, what proportion, y, would he select?
b. Is the fee (percentage of the investment in your fund, deducted at the end of the year) that
you can charge to make the client indifferent between your fund and the passive strategy
affected by his capital allocation decision (i.e., his choice of y )?
Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be either
$70,000 or $200,000 with equal probabilities of .5. The alternative risk-free investment in
T-bills pays 6% per year.
a. If you require a risk premium of 8%, how much will you be willing to pay for the
portfolio?
b. Suppose that the portfolio can be purchased for the amount you found in ( a ). What will
be the expected rate of return on the portfolio?
c. Now suppose that you require a risk premium of 12%. What is the price that you will be
willing to pay?
d. Comparing your answers to ( a ) and ( c ), what do you conclude about the relationship
between the required risk premium on a portfolio and the price at which the portfolio
will sell?

4. a. The expected cash flow is: (0.5 × $70,000) + (0.5 × 200,000) = $135,000 With a risk
premium of 8% over the risk-free rate of 6%, the required rate of return is 14%. Therefore, the
present value of the portfolio is: $135,000/1.14 = $118,421
b. If the portfolio is purchased for $118,421, and provides an expected cash inflow of
$135,000, then the expected rate of return [E(r)] is derived as follows: $118,421 × [1 + E(r)] =
$135,000 Therefore, E(r) = 14%. The portfolio price is set to equate the expected rate or return
with the required rate of return.
c. If the risk premium over T-bills is now 12%, then the required return is: 6% + 12% = 18% The
present value of the portfolio is now: $135,000/1.18 = $114,407
d. For a given expected cash flow, portfolios that command greater risk premia must sell at
lower prices. The extra discount from expected value is a penalty for risk.

5. Consider a portfolio that offers an expected rate of return of 12% and a standard deviation
of 18%. T-bills offer a risk-free 7% rate of return. What is the maximum level of risk aversion
for which the risky portfolio is still preferred to bills?
When we specify utility by U = E(r) – 0.5Aσ 2The utility level for the risky portfolio is: U = 0.12 –
0.5A(0.18), the utility level for T-bills is: 0.07 2In order for the risky portfolio to be preferred to
bills, the following inequality must hold: = 0.12 – 0.0162A 0.12 – 0.0162A > 0.07 ⇒ A <
0.05/0.0162 = 3.09 A must be less than 3.09 for the risky portfolio to be preferred to bills.

Suppose that the borrowing rate, r Bf=9% is greater than the lending rate, r f = 7%. Show
graphically how the optimal portfolio choice of some investors will be affected by the higher
borrowing rate.
Which investors will not be affected by the borrowing rate?
The lending and borrowing rates are unchanged at rf = 7%, rBf =9%. The standard deviation of
the risky portfolio is still 22%, but its expected rate of return shifts from 15% to 17%.
The slope of the two-part CAL is
E(rP) – rf /oP for the lending range
E(rP) - r Bf/0P for the borrowing range
Thus in both cases the slope increases: from 8/22 to 10/22 for the lending range, and from 6/22
to 8/22 for the borrowing range.

CHAPTER 9
11. Joan McKay is a portfolio manager for a bank trust department. McKay meets with two
clients,Kevin Murray and Lisa York, to review their investment objectives. Each client
expresses an interest in changing his or her individual investment objectives. Both clients
currently hold well-diversified portfolios of risky assets.
a. Murray wants to increase the expected return of his portfolio. State what action McKay
should take to achieve Murray’s objective. Justify your response in the context of the CML.
b. York wants to reduce the risk exposure of her portfolio but does not want to engage in
borrowing or lending activities to do so. State what action McKay should take to achieve
York’s objective. Justify your response in the context of the SML.
11. a. McKay should borrow funds and invest those funds proportionately in Murray’s existing
portfolio (i.e., buy more risky assets on margin). In addition to increased expected return, the
alternative portfolio on the capital market line will also have increased risk, which is caused by
the higher proportion of risky assets in the total portfolio.
b. McKay should substitute low beta stocks for high beta stocks in order to reduce the overall
beta of York’s portfolio. By reducing the overall portfolio beta, McKay will reduce the
systematic risk of the portfolio, and therefore reduce its volatility relative to the market. The
security market line (SML) suggests such action (i.e., moving down the SML), even though
reducing beta may result in a slight loss of portfolio efficiency unless full diversification is
maintained. York’s primary objective, however, is not to maintain efficiency, but to reduce risk
exposure; reducing portfolio beta meets that objective. Because York does not want to engage
in borrowing or lending, McKay cannot reduce risk by selling equities and using the proceeds to
buy risk-free assets (i.e., lending part of the portfolio).
9. Consider the following table, which gives a security analyst’s expected return on two stocks
for two particular market returns:
Market Return Aggressive Stock Defensive Stock
5% 22% 6%
25 38 12
a. What are the betas of the two stocks?
Ba= (-.02 - .38) / (.05 -.25) = 2

Bd = (.06 -.12) /(.05-.25) = 0.30

b. What is the expected rate of return on each stock if the market return is equally likely to be
5% or 25%?
E(rA ) = 0.5 x (-.02 + .38) = .18 = 18%
E(rD) = 0.5 x (.06 +.12) = 0.09 = 9%
c. If the T-bill rate is 6% and the market return is equally likely to be 5% or 25%, draw the
SML for this economy.
The SML is determined by the market expected return of [0.5 × (.25 + .05)] = 15%, with βM = 1,
and rf = 6% (which has βf = 0). See the following graph:
E(r) = .06 + β × (.15 - .06)
d. Plot the two securities on the SML graph. What are the alphas of each?
Based on its risk, the aggressive stock has a required expected return of:
E(rA ) = .06 + 2.0 × (.15 - .06) = .24 = 24%
αA = actually expected return - required return (given risk)
= 18% - 24% = -6%
Similarly, the required return for the defensive stock is:
E(rD) = .06 + 0.3 × (.15 - .06) = 8.7%
αD = actually expected return - required return (given risk)
= .09 - .087 = +0.003 = +0.3%
e. What hurdle rate should be used by the management of the aggressive firm for a project
with the risk characteristics of the defensive firm’s stock?

20. Two investment advisers are comparing performance. One averaged a 19% rate of return
and the other a 16% rate of return. However, the beta of the first investor was 1.5, whereas
that of the second was 1.
a. Can you tell which investor was a better selector of individual stocks (aside from the issue
of general movements in the market)?
To determine which investor was a better selector of individual stocks we look at abnormal
return, which is the ex-post alpha; that is, the abnormal return is the difference between the
actual return and that predicted by the SML. Without information about the parameters of this
equation (risk-free rate and market rate of return) we cannot determine which investor was
more accurate.
b. If the T-bill rate were 6% and the market return during the period were 14%, which
investor would be the superior stock selector?
If rf = 6% and rM = 14%, then (using the notation alpha for the abnormal return):

α1 = .19 - [.06 + 1.5 × (.14 - .06)] = .19 - .18 = 1%

α 2 = .16 - [.06 + 1 × (.14 - .06)] = .16 - .14 = 2%
Here, the second investor has the larger abnormal return and thus appears to be the superior
stock selector. By making better predictions, the second
c. What if the T-bill rate were 3% and the market return were 15%?
If rf = 3% and rM = 15%, then:
α1 = .19 - [.03 + 1.5 × (.15 - .03)] = .19 - .21 = -2%
α2 = .16 - [.03+ 1 × (.15 - .03)] = .16 - .15 = 1%
Here, not only does the second investor appear to be the superior stock selector, but the first
investor's predictions appear valueless (or worse).
CHAPTER 11
10. Growth and value can be defined in several ways. “Growth” usually conveys the idea of a
portfolio emphasizing or including only issues believed to possess above-average future rates
of per-share earnings growth. Low current yield, high price-to-book ratios, and high price-of
earnings ratios are typical characteristics of such portfolios. “Value” usually conveys the idea
ofportfolios emphasizing or including only issues currently showing low price-to-book ratios,
low price-to-earnings ratios, above-average levels of dividend yield, and market prices
believed tobe below the issues’ intrinsic values.
a. Identify and provide reasons why, over an extended period of time, value-stock investing
might outperform growth-stock investing.
b. Explain why the outcome suggested in ( a ) should not be possible in a market widely
regarded as being highly efficient.
10. a. The earnings (and dividend) growth rate of growth stocks may be consistently
overestimated by investors. Investors may extrapolate recent growth too far into the future
and thereby downplay the inevitable slowdown. At any given time, growth stocks are likely to
revert to (lower) mean returns and value stocks are likely to revert to (higher) mean returns,
often over an extended future time horizon.
b. In efficient markets, the current prices of stocks already reflect all known relevant
information. In this situation, growth stocks and value stocks provide the same risk-adjusted
expected return.