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IAI Actuarial Core Principles · Economic Modelling · Capital Asset Pricing Model (CAPM)

Which statement correctly distinguishes the Capital Market Line from the Security Market Line?

The CML shows expected return against standard deviation and applies only to efficient portfolios. The SML shows expected return against beta and applies to all assets and portfolios. Their slopes also differ: the CML slope is the premium per unit of total risk.

  1. AThe CML plots expected return against beta for all securities
  2. BThe CML plots expected return against standard deviation for efficient portfolios only, while the SML plots expected return against beta for any asset or portfolioCorrect
  3. CThe SML applies only to efficient portfolios and the CML to individual securities
  4. DBoth lines have slope equal to the market risk premium
  5. The CML has the market beta as its slope

Explanation

The CML is in expected return and standard deviation space and holds only for efficient portfolios, combining the risk-free asset and the market portfolio. The SML is in expected return and beta space and holds for every asset. The CML slope is the market price of risk, (E(Rm)-rf)/sigma_m, not the risk premium.

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