Final answer:
CAL, CML, and SML are key concepts in finance relating to the risk and return of securities and portfolios. The CAL represents combinations of risk-free and risky assets, the CML is a special case of CAL using the market portfolio, and the SML relates an asset's return to its systematic risk. Understanding their differences is critical for informed investment decision-making.
Step-by-step explanation:
The Capital Asset Pricing Model (CAPM), the Security Market Line (SML), and the Capital Market Line (CML) are fundamental concepts in finance relating to the risk and return of securities and portfolios. They all originate from the Modern Portfolio Theory (MPT) but serve different purposes and comprise different assumptions.
- CAL (Capital Allocation Line) represents a line that shows all possible combinations of risk-free assets and a risky portfolio that an investor might consider. Each point on the CAL has a different proportion of the risk-free asset and the risky portfolio.
- CML (Capital Market Line) is a special case of the CAL where the risky portfolio is the market portfolio, which includes all investable assets. It shows the relationship between the expected return of the market portfolio and the standard deviation (or risk).
- SML (Security Market Line) depicts the expected return of an individual asset as a function of its systematic risk, or beta, compared to the overall market. The SML is derived from the CAPM and helps in determining whether a security is undervalued or overvalued.
Main differences include:
- CAL can be drawn with any risky portfolio, not necessarily the market portfolio, while the CML exclusively involves the market portfolio.
- The CML represents the risk-return tradeoff for efficient portfolios (those that offer the highest return for a given level of risk), whereas the SML deals with individual securities and their expected returns relative to their beta.
- The SML considers both systematic and unsystematic risk in its measure, while the CML is concerned only with the market's systematic risk.
Understanding the concepts of CAL, CML, and SML is essential for students and professionals in finance since they are crucial for making informed decisions about investment portfolios and individual securities.