Comparison Of Security Market Line And Capital Market Line

This project report consists capital market line and security market line, their importance and graphical representation. Importance of minimum variance portfolios, capital assets pricing model are also covered under this report.

TASK 1

1 Comparison of security market line and capital market line

Security market line: It is an element that represent the risk and return of capital asset pricing model. It demonstrates the relation between expected rate of return and risk measured by beta. It is mainly drawn on a chart which is a graphical presentation of CAPM. The x-axis of the chart reflects the risk and y-axis reflects the expected return. When it is used in portfolio management it reflects the opportunity cost of an investment (Baños-Caballero, García-Teruel and Martínez-Solano, 2014). It is an graphical representation of market risk involved in an investment and its return in future which is based on assumption.

Benefits of SML:

• It is an investment evaluation methods that can reflect risk and return for the securities and it is mainly based on past assumptions.
• It can provide the forecasted idea to the investors about the risk and return on their securities for the future period.
• It is very important because it can provide the information of efficient and non efficient portfolios.
• It helps the investor by facilitating his work while calculating future value of a portfolio.

Here is a graph that can help to understand the concept of Security Market Line easily:

Source: Security Market Line, 2018

The above graph reflects that, higher the risk higher the rate of market return, if there is no risk in the market than the holder of security is going to get a fixed percent of return which is called risk free rate. When the level risk increases the return rate will also increase for that particular security. Here, Beta reflects level of risk for the portfolios.

Capital market line: It is the straight line which is drawn from the point of risk free assets to the executable area of risky assets. The conjunction point of this line represents the market portfolio of investors. This line is mainly concerned with the representation of risk free assets and market portfolio. It is a graphical representation in which risk free assets are represented by L and market portfolios are presented by M (Bender, 2013).

Benefits of CML:

• It shows the combination of risk free and risky assets, which help the investors to choose best portfolio.
• It only provides the idea of efficient portfolio which saves the time of investors.
• The major benefit of CML is that the investor will be always up to date with the securities industry and have the information of economic ups and downs.

CML can be understood easily with the help of following graph:

Source: Capital Market Line, 2018

In capital market line there are various portfolios, and it is used to determine efficient frontier from all the portfolios. In above graph risk is represented by standard deviation, the chart reflects the efficient portfolio in which market risk and return is equal. Risk free return is fixed for the portfolio holder. The curve reflects the risk and return of various portfolios and efficient portfolio is the point where the investor can get efficient return. So the investor can choose the option when the risk and return are proportionally equal.

Difference between SML and CML:

The difference of SML and CML can be understood properly with the help of following graphical representation:

Source: SML v/s CML, 2014

TASK 2

2 Minimum variance portfolio and its importance

Minimum variance portfolio:  It is a portfolio which is used to combine securities to minimize the activities of price movement of the whole portfolio. It indicates a well diversified portfolio that consists of particularly risky assets. These assets are hedged when traded with each other and it results in lower risk for the expected rate of return on those assets. If there are constant changes in the price of securities, it will increase the possibility of higher risk. Hence if an investor is willing to minimize the risk they are also wanting that ups and down should be minimised for the security. Most of the minimum variance portfolios differentiate from a traditional mix of bonds and stocks. It is a mixture of highly volatile individual securities with low risk, rather then a mixture of low risk and high risk which is a combination of bonds and stocks (Brealey, Myers and Marcus, 2012).

 Importance of minimum variance portfolio:

• It combines securities that help to minimize the constant prices changes of the security.
• It helps to reduce the risk involved in the various assets by trading them with each other.
• It is different from traditional portfolio, which is a combination of higher and lower risk of security, it only combines the securities with lower risks.
• Minimum variance portfolios provide better risk adjusted return on investment that increase the interest of investors.
• It is based on weighted average method which helps to reduce the risk incurred in assets or securities.
• Investors wish to get quick returns on their securities, thus this portfolio help them to increase their return and get the higher return quick as compare to other securities (Brigham and Houston, 2012).

Minimum variance portfolio can be understood well with the help of following example:

Example: The portfolio invests in five stocks with an allocation of 12%, 15%, 17%, 20% and 36%. Calculate the standard deviation and average of each stock:

Average for each stock is 4.25%, 2.23%, 4.91%, -0.67% and 1.27% for stock A to stock E respectively, and standard deviation for each stocks are 0.054, 0.012, 0.040, 0.024 and 0.045 for each stock for a year.

TASK 3

3 CAPM equation and its importance

Capital asset pricing model: It is a model which is used to find out a empirically suitable required rate of return on a security. This return helps the investor while making decision about adding assets to a well varied portfolio. It was introduced by Jack Treynor, William F. Sharpe, John Linter, Jan Mossin. The main function of capital asset pricing model is to determine relation between systematic risks and expected rate of return on particular assets. It is used by large organisation in finance for the pricing of risky assets or securities, getting returns for assets and calculating cost of capital (Capital Asset Pricing Model, 2018).

Formula: Ra= Rrf + [Ba* (Rm- Rrf)]

Here,

 Ra = Expected return on a security

 Rrf = Risk free rate

 Ba = Beta of the security

 Rm = Expected return on market

  Dividend growth model: It is mainly used to calculate intrinsic value of a stock, which is based on current market conditions. It helps to calculate the fair value of assets, assuming that the dividends increase either at a stabilized rate or different rates during the period. It determine the value of stock whether it is overvalued or under valued. It helps the investors to compare their security's company to other companies (Higgins, 2012). It assumes various conditions such as company's business model which is stable, if there are significant changes, company's growth rate whether it is constant or not, company's stable financial leverage etc.

Formula: Value of stock = D1/ (k-g)

Here,

 D1 = next year's expected annual dividend per share

 K = The investor's discount rate or required rate of return

 g = The expected dividend growth rate

Importance of Capital assets growth model: Capital assets growth model is more relevant while calculating required rate of return as compare to Dividend growth model. The importance of CAPM is described below, that reflects the relevancy of this model:

• It is sued when the investor is willing to grow its investment, it takes into account the risk of security in general and the risk of the company whose share is issued. Hence it helps the investor be aware of risk and help them to invest in various companies so that if one company declines they can covers the return from another. This can give protection to their whole portfolio. But in dividend growth model the investor will only have the idea of dividend and the investor only able to invest in one company if the company declines then the value of his security will also decline and investor may have to face a loss. Divined growth model can only determine the financial health of the company and if the company can raise funds then dividend will be provided to the investors (Oikonomou,  Brooks and Pavelin, 2012).
• In capital asset pricing model the investor can reduce the possibility of risk, and determine the expected rate of return and if the market goes down, they still have chance to get back their money. In dividend growth model if a company goes down and facing a loss, in this situation the managers may decide to cut the dividend to cover the loss and the investor wont be able to get a return on their amount.
• In capital asset pricing model the investor can make good and large returns for this the investor have to hold the security for a long term. It is also same for dividend growth model but the dividend will be received per quarter and if the investor is wiling to get the dividend then he must hold the security for whole quarter.
• Capital assets pricing model evaluates the risk and return involved in the the security which is compared to the market average. Dividend growth model is based on the value of dividend of a share (Wang and Sarkis, 2013).

It is cleared from all the above mentioned points that capital asset pricing model is more relevant while calculating required rate of return because while calculating return from CAPM method the investor must have the idea of return and risk involved in the security but in second method the investor will only have the idea of return not the risk.

CONCLUSION

From the above project report it has been concluded that, corporate financial management is a process of evaluating and analysing various sources of funds and cost of its capital. Security and capital market line are two methods that are used to evaluate efficient and non efficient portfolios. Minimum variance portfolio is used to minimize the risks of securities by combining various securities together. Capital asset pricing model is used to determine the expected return and risk which may affect the return on a particular security or asset.

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REFERENCES

• Aebi, V., Sabato, G. and Schmid, M., 2012. Risk management, corporate governance, and bank performance in the financial crisis. Journal of Banking & Finance. 36(12). pp.3213-3226.
• Baños-Caballero, S., García-Teruel, P. J. and Martínez-Solano, P., 2014. Working capital management, corporate performance, and financial constraints. Journal of Business Research. 67(3). pp.332-338.
• Bender, R., 2013. Corporate financial strategy. Routledge.
• Brealey, R. A., Myers, S. C. and Marcus, A. J., 2012. Fundamentals of corporate finance. McGraw-Hill/Irwin,.
• Brigham, E. F. and Houston, J. F., 2012. Fundamentals of financial management. Cengage Learning.
• Higgins, R. C., 2012. Analysis for financial management. McGraw-Hill/Irwin.
• Oikonomou, I., Brooks, C. and Pavelin, S., 2012. The impact of corporate social performance on financial risk and utility: A longitudinal analysis. Financial Management. 41(2).  pp.483-515.
• Wang, Z. and Sarkis, J., 2013. Investigating the relationship of sustainable supply chain management with corporate financial performance. International Journal of Productivity and Performance Management. 62(8). pp.871-888.
• Online:
• Capital Asset Pricing Model. 2018. [Online]. Available through:
  <https://study.com/academy/lesson/capital-asset-pricing-model-capm-definition-formula-advantages-example.html>

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