Answer To: FIN200 Assignment, Trimester 2 2018 Explain and graphically depict how Security Market Line (SML) is...
Sarabjeet answered on Sep 18 2020
Security Market Line
Security Market Line
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Contents
Difference between Security Market Line (SML) and Capital Market Line (CML) 3
Importance of minimum variance portfolios 6
Why CAPM equation might be more relevant than other equations when calculating required rate of return. 8
References 11
Difference between CapitalMarket Line andSecurityMarket Line
The Modern portfolio theory discovers how stakeholders can build the portfolios in the manner that reduces risk levels as well asincreasesprofits and returns. The Capital Asset Pricing Model is a significant component of the portfolio model, which debates the Security Market Line along with the Capital Market Line. These philosophies are very complex and maysimply be misunderstood. SML, also acknowledged as a feature line, is the graphical depiction of the market risk as well as return at the specified time. A Security market line is a depiction of the CAPM model in the graphical format. The SML displays the risk level for the given return level. Y-axis signifiesa level of the expected return,in addition X-axis represents the risk level symbolized by β. Each security which belongs to SML itself is deemed fair, so the risk level matches to level of return. Any security on top of SML is underestimated security because it provides a higher return on the risks that are generated. Any securities under SML are more because it provides less reward for a given risk. CML is a line which shows the rate of return, which reliesupon the risk-free rate of return as well as the risk level of a particular portfolio (Christiana, Setiana and Mamduch, 2016). One main difference between SMLand CMLis the method of measuring risk aspects. Although standard deviation is an indicator of CML risk, beta coefficient ascertainsrisk factor of SML. The CML quantifies risk by overall risk factororstandard deviation. Conversely, SML quantifies risk with the help of beta, which assists in finding portfolio risk contributions. Although the capital market line chart defines an effective portfolio, the stock market line chart defines an effective and inefficient portfolio. When computing the return, the expected return of CML portfolio is presented with the Y-axis. Conversely, for the SML, the return of security is shown with the Y-axis. For SML, the standard deviation of combination is presented with X axis, while for SML, the beta of protection is displayed with the X axis (Deeley, 2012). If risk-free assetsand market portfolioare determined by the CML, then all security aspects are ascertained by the SML.Not like capital market line, the security market line displays the expected return on specific assets. CML ascertains the benefit or risk of a valid portfolio, besides SML shows the return or risk of individual stocks. Capital market line is in line from the risk-free assets to the risk asset market portfolio. Y axis of the CML depicts the expected return,in addition, the X axis denotes the standard deviation or risk level. Use CML in the CAPM prototypical to demonstrate the return that may be obtained by financing in the risk-free assets and the increase in returns when investing in higher risk assets (Holst, 2015). This line clearly displaysa level of return and risk. As the risk increases, the level of return continues to increase. As a result, CML has played a role in helping investors determine the proportion of the funds to be financed in various risk-freeandrisks assets. Both SML and CML are concepts which are related to each other because they provide a graphical representation of the return level which provides for the risks of the securities. Both SML and CML are significant concepts in the latest portfolio theory as well as are closely linked to the CAPM. There are many differences amid the two; One main difference is the way to measure risk. Risk is quantified by the standard deviation in the CML however, is quantified by the β in the SML. The CML depicts the risk and return level of the portfolio, whileSML shows the returnand risklevelof specific securities (Jylha, 2013).
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Capital Market Line
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Importance of minimum variance portfolios
Portfolio differences are indicators that measure how total actual return of the group of various securities that make up a portfolio varies over the time. The portfolio variance statistic is computed utilizing standard deviation of every security in the portfolio and the connection of every pair of securities in portfolio (Obrimah, Alabi and Ugo-Harry, 2015).The stock portfolio with the lowest volatility (beta) is therefore the least sensitive to risk. It maximizes the utilization of the diversification to attain a final level of risk that is below the specific risk level of every single stock it comprises. One of investment policies aimed at decreasing portfolio risk is the Minimum Variance Portfolio (MVP), that is based upon Markowitz's (1952, 1959), a Noble Award-winninglatest portfolio model. Optimization program ascertains the portfolio weights to diversify the securities in mucheffective manner and portfolio has lowermost volatility. The return rate of MVP is similar to its benchmark capitalization weighted index, but the standard deviation is 25-30% lower. Therefore, there is no doubt that the minimum variance equity strategy has become popular, and since 2007, many tradable indices and investment funds using MVP have been started (Richard and Roncalli, 2015). The minimum variance portfolio is a portfolio model consisting of separately volatility investments but is considered low risk by some when put together.
A portfolio of investments typically defines a portfolio of the investment securities kept in an account and a portfolio of accounts and securities held by an investor. Therefore, in order to establish minimum variance portfolio, investors required to link low volatility investments or combinations of volatility investments. The latter's portfolio is related to establishing minimum variance portfolio. Investments with low correlations can be defined as investments that perform in a different way in the similar market as well as economic environment. It is a majorinstance of diversity. When investors diversify their portfolios, they are basically looking to decrease volatility, which is basis of minimum variance portfolio – a varied portfolio of the securities. MVP has some bias compared to market-weighted portfolios. The latter may be deemed a market bias policy, which directs to its own partiality as well towards large-scale related factors, for example,low leverage and high liquidity, and obviously large-scale (Sinha, 2012). Observing the active unveiling of MVP logically found the reverse distribution of size, mobility and leverage. Whether MVP is allocated to scale as well as liquidity and over-allocation for leverage, and whether they merelydecrease the inherent bias of benchmark against these aspects is controversial. There is also wide research presenting that the liquidity is often a premium paid by the investors and leads to a poor performance of portfolio in a long run. MVP tends to strongly exceed market capitalization. Weight the portfolio while reducing long-term risks (Tsuji, 2013). To believe that this inclination will endure and not merely luck, it is significant to comprehend the underlying causes of this behaviour, particularly since it denies the conviction that more risks will incline to maximum returns, for example, CAPM. This behaviour is not fullycontrary to the CAPM, because market capitalization weighted index is not essentially a “market portfolio”. So, market capitalization-weighted portfolios bear few diversifiable risks that are not covered by any risk premium. In the theory, MVP does not take upon these risks, consequently it can benefit from reducing risk without decreasing revenue. Though, this only does not describe its excellent performance. MVP seeks to minimize risk. As a result, they tend to seek assets with lower volatility while reducing the allocation of highly relevant assets. In doing so, MVP selects assets that may not be priced. Since this underestimation is decreased and factors become more unstable and related to further assets, their weight is decreased in MVP as well as might even be eliminated. In this procedure, MVP has achieved excellent results (Torri and Giacometti, 2017).
CAPM equation might be muchpertinent when calculating the required rate of return.
In the financial sector, Capital Asset Pricing Model is theprototypical utilized to ascertain the theoretically suitableessential rate of return for the asset to make choicesregarding adding assets to thevaried portfolio. The model considers the sensitivity of an asset to non-distributable risk and is generally expressed in the terms of number of beta (β) in financial industry, in addition to the predictable and expected returns of market (Wibowo, 2014).Capital Asset Pricing Model is the model whichdefines the relationship amonginvestment securities risks and expected returns. It displays that expected return of the security is equal to the risk-free return along with risk premium, andrisk premium is based upon the beta value of security. The CAPM was developed to explain the way in which risk securities are priced in the market. Markowitz's theory is more theoretical, and CAPM aims to make stock valuations in a more practical way. There is no doubt that the mean-variance method for assessing investment risk based on Markowitz's development. It explains the behaviour patterns of investors in building portfolios.
CAPM is computed as per the subsequent formula:
ra = rrf+ Ba (rm-rrf);
Ra = Projected return on the security
Rrf = Risk-free rate
Ba = Beta of a security
Rm = Expected return on the market
The CAPM method is utilized to compute expected return on the investable assets. This is based upon the principle that the stockholders have conventions about systemic risks (also recognized as non-distributable risks or market risks) that require to be reimbursed in a form ofrisk premium - market returns outweigh the risks - free rates. By financing in securities, investors want maximum returns to take on extra risks.CAPM just considers systemic risks as well as reflects the realism that maximum investors have varied portfolios, of which the non-systematic risks have been largely eliminated (Yen, 2015). It is a theoretical derivation between required returns and systemic risk, often requiring experiential research as well as testing. CAPM is generallyperceived as the better way to compute cost of the equity than the Dividend Growth Prototypicalas it clearly considers system's level of systemic risk related to stock market as whole. It is considerablyfiner thanWACC in giving a discount rate for investment assessment.A CAPM is generally utilized to ascertain what the appropriate cost of the investment should be. When using CAPM to compute the return rate on a risky asset, the ratio can be utilized to discount future cash flows of investment in the current value, to get the fair value of the investment.Further, once a fair value of investment is calculated, it is compared to market price. If the price is projected to be greater than market price, the stock is considered to be cheap. If the price estimate is low, consider overvaulting the inventory (Zakamulin, 2014).In real world, stockholders get greater risk returns, and they are much concerned about company-related menaces than the market-related menaces, unless they are skilled investment analysts. The organization was found to utilize CAPM to ascertain the organization's cost of equity, estimate a needed return on the department or line of business, ascertain the minimum interest rate for the organisation's investment, and assess the performance of the investment department in terms of cost and return. These minimum rates of the return are usually the required rate of the return, while the company assesses the historical performance of each department's costs and related returns. In the case of utilities, CAPM can be used to estimate the fees and rates charged for the payment of fees. CAPM is used to manage utilities from a cost perspective. Historical returns and beta are utilized to choose the appropriate risks in portfolio. The CAPM is utilized to choose securities, to make a portfolio and to assess performance of a portfolio. So, it is very beneficial tool for the portfolio managementandinvestment analysis. CAPM considers a specific form of utility function (where only first and second moments are important, i.e., the risks are different, such as classified utility), or returns to the property, and probability distribution will be fully completed in the first two moments. Under these circumstances, the CAPM depicts that cost of equity capital is ascertained only by the beta. Though there have not been many empirical tests in it and due to its simplicity and pragmatism in different situations, more modern property pricing as well as portfolio selection systems (for example,Merton's portfolio problemalong with Arbitrage pricing model), the CAPM is still very widespread.
References
Christiana, A., Setiana, E. and Mamduch, M. (2016). The Empirical Relationship between Stock Return and Trading Volume based on Stock Market Cycles. Indonesian Capital Market Review, 8(1).
Deeley, C. (2012). A Simple Derivation of the Capital Asset Pricing Model from the Capital Market Line. SSRN Electronic Journal.
Holst, G. (2015). A More Neutral Measure for Sensitivity. Optik&Photonik, 10(4), pp.47-49.
Jylha, P. (2013). Margin Constraints and the Security Market Line. SSRN Electronic Journal.
Obrimah, O., Alabi, J. and Ugo-Harry, B. (2015). How Relevant Is the Capital Asset Pricing Model (CAPM) for Tests of Market Efficiency on the Nigerian Stock Exchange?. African Development Review, 27(3), pp.262-273.
Richard, J. and Roncalli, T. (2015). Smart Beta: Managing Diversification of Minimum Variance Portfolios. SSRN Electronic Journal.
Sinha, R. (2012). Application of Capital Asset Pricing Model Based on the Security Market Line. Adarsh Journal of Management Research, 5(1), p.17.
Torri, G. and Giacometti, R. (2017). Sparse Precision Matrices for Minimum Variance Portfolios. SSRN Electronic Journal.
Tsuji, Y. (2013). A New Model for Calculating Required Return on Investment. SSRN Electronic Journal.
Wibowo, B. (2014). Price Manipulation in Indonesian Capital Market: Empirical Analysis on Stockbroker’s Behavior and Interaction Pattern between Domestic Investors and Foreign Investors. Indonesian Capital Market Review, 2(1).
Yen, Y. (2015). Sparse Weighted-Norm Minimum Variance Portfolios. Review of Finance, 20(3), pp.1259-1287.
Zakamulin, V. (2014). The Role of Covariance Matrix Forecasting Method in the Performance of Minimum-Variance Portfolios. SSRN Electronic Journal.
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