FACULTY OF COMMERCE

DEPARTMENT OF BUSINESS STUDIES

NAME MARYLINE PFIDZE

REG NUMBER R183930J

PROGRAMME HBBSFINBC

COURSE NAME INVESTMENT ANALYSIS AND PORTFOLIO MGMNT

COURSE CODE BSFB403

LECTURER P JECHECHE

ASSIGNMENT 2
COMPARE AND CONTRAST A CAPITAL MARKET LINE AND A
CHARACTERISTIC LINE WITH REFERENCE TO PORTFOLIO THEORY. ALSO
EXPLAIN THE IMPLICATION OF EACH OF THEM TO THE PORTFOLIO
MANAGER.
Whenever an investment portfolio is created, the capital asset pricing model (CAPM) helps
assess the risk and estimate the possible returns from the investments made. In order to
determine the returns on investment and the return of securities portfolio with the help of
systematic risk involved in it, the CAPM provides two ways namely capital market line
(CML) and characteristic line or security market line (SML).

CAPITAL MARKET LINE (CML)

The Capital Market Line is a graphical representation of all the portfolios that optimally
combine risk and return. CML is a theoretical concept that gives optimal combinations of a
risk-free asset and the market portfolio. Capital market line is the tangent line drawn from the
point of the risk-free asset to the feasible region for risky assets. The tangency point M
represents the market portfolio, so named since all rational investors should hold their risky
assets in the same proportions as their weights in the market portfolio.
The slope of the Capital Market Line (CML) is the Sharpe ratio of the market portfolio.
The efficient frontier represents combinations of risky assets.  The point of tangency (M) is
the most efficient portfolio. Moving up the CML will increase the risk of the portfolio, and
moving down will decrease the risk. Subsequently, the return expectation will also increase
or decrease, respectively.

CHARACTERISTIC LINE (SECURITY MARKET LINE)-SML

Security market line is the 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. Security characteristic line is a regression line, plotting performance of a particular
security or portfolio against that of the market portfolio at every point in time.

The formula for plotting the SML is required return = risk-free rate of return + beta (market
return - risk-free rate of return).

SIMILARITIES OF CML AND SML

The CML and SML are both based on the trade-off between risk and return.

Both lines intersect the vertical axis or the y-axis at the risk free rate point.
DIFFERENCES BETWEEN CML AND SML
 Definition.

The capital market line determine an average rate of success or loss in market share. It is a
line used to show the rate of return which depends on risk free rate and levels of risk for a
specific portfolio. On contrary, security market line helps an investor to determine the market
risk in an investment thus a graphical representation of the markets risk and return at a given
time.

 Portfolios.

CML defines only functioning or efficient portfolios. That is it determines the risk of return
for efficient portfolios.it is used for portfolio of assets because it measures the total risk.
Whereas the SML defines both functioning and non-functioning portfolios. It demonstrates
the risk or return for both individual stocks or assets and a portfolio of assets for it measures
the volatility of the investment.

 Measuring risk.

The CML uses standard deviation to calculate risk. It is shown along the x-axis of the graph
and the expected return of the portfolio is shown along the y-axis. However SML uses beta
coefficient to calculate risk, it is shown along the x-axis of the graph. Also the returns of the
securities is shown along the y-axis.

 Risk considered.

Capital market line considers both systematic and non-systematic risks whereas characteristic
line only takes into account systematic risk. Systematic risk or market risk refers to the risk
inherent to the entire market, reflecting the impact of economic, geo-political and financial
factors. It affect aggregate outcomes such as broad market returns, total economy-wide
resource holdings, or aggregate income.  Unsystematic or diversifiable risk refers to the
probability of a loss within a specific industry or security. It is associated with a particular
investment.

 Objective.

CML describes only market portfolios and risk free investment. It measures risk through a
total risk factor standard deviation. However SML illustrate all security factors measuring
risk through beta which helps to find the security’s risk contribution for the portfolio.

IMPLICATIONS OF CML AND SML TO THE PORTFOLIO MANAGER.

Having compared and contrasted capital market line and characteristic line with reference to
portfolio theory, they have vital effects to the portfolio managers in decision making and
portfolio management. Some of these implications includes the following points given below:

The capital market line draws its basis from the capital market theory as well as the capital
asset pricing model. It is a theoretical representation of different combinations of a risk-free
asset and a market portfolio for a given Sharpe ratio. As we move up along the CML, the risk
in the portfolio increases and so does the expected return and vice versa. It is superior to the
efficient frontier because the efficient frontier only consists of risky assets or market
portfolio. We can use the CML formula to find the expected return for any portfolio given its
standard deviation. Therefore the CML is used by portfolio managers to derive the amount of
return that investors would expect to take a certain amount of risk in the portfolio.

However, the major drawback of capital market line in real market conditions is that CML is
based on the same assumptions as CAPM. There are taxes and transaction costs which can
significantly differ for various investors.

The security market line is commonly used by portfolio managers and investors to evaluate
an investment product that they're thinking of including in a portfolio. The SML is useful in
determining whether the security offers a favourable expected return compared to its level of
risk. When a security is plotted on the SML chart, if it appears above the SML, it is
considered undervalued because the position on the chart indicates that the security offers a
greater return against its inherent risk. Conversely, if the security plots below the SML, it is
considered overvalued in price because the expected return does not overcome the inherent
risk. The SML is frequently used in comparing two similar securities that offer approximately
the same return, in order to determine which of them involves the least amount of inherent
market risk relative to the expected return. The SML can also be used to compare securities
of equal risk to see which one offers the highest expected return against that level of risk.

CONCLUSION.

Both capital market line and characteristic line help portfolio managers to get information on
the risk and return of a portfolio. They are very useful financial tools as these managers make
reference to them in order to make an informed decision on the securities or investment to
make.
REFERENCES.