How the Capital Market Line and Security Market Line Differ in CAPM Pricing

Summary

This explanation distinguishes the Capital Market Line (CML) from the Security Market Line (SML). The CML relates expected return to standard deviation for efficient portfolios, while the SML relates expected return to beta for individual securities or portfolios under CAPM. Therefore, the CML describes attainable portfolio choices rather than serving as a direct test of whether an individual asset is overpriced or underpriced.

The answer says portfolios below the CML are dominated by an efficient portfolio with the same risk, while points above it are unattainable under the model’s assumptions. It also explains that CAPM rewards systematic risk because diversification is assumed to remove idiosyncratic risk without a premium. This is a conceptual clarification, not an empirical pricing test; its conclusions depend on the CAPM framework and the availability of the assumed efficient market portfolio.

Key ideas

• The CML connects expected return and total volatility for efficient portfolios.
• The SML connects expected return and beta for securities or portfolios.
• A point below the CML represents an inefficient portfolio relative to available efficient choices.
• CAPM assigns a risk premium to systematic risk, assuming idiosyncratic risk can be diversified away.

Tags

# CML, SML and Pricing


# CML, SML and Pricing












hi i have a confusion about what conclusion I can draw regarding the pricing from the Capital market line and security market line.

As far as I know, if an asset that is lying below the SML is overpriced while above the SML is underpriced, which makes sense to me. However, why can't I draw such conclusion from the CML?? I guess it may because one is measuring beta while the other concerns standard deviation... What does "fairly-priced" mean??? Do we only need to concentrate on systematic risk (since it reflects from SML) on pricing??

Thank you!

## Answer by Neeraj (score 1, accepted)

https://quant.stackexchange.com/a/24353

First understand that CML shows relationship between portfolio expected return and standard deviation, while SML shows relationship between a stock expected return and beta.

Any portfolio above CML is not achievable. It means you can not create portfolio that will provide you higher return for a given risk than what is available on CML. And investor will never choose any portfolio below the CML because he can always get higher return by choosing portfolio on CML for a given risk.

Further, CAPM only provide risk premium for systematic risk only because it assumes idiosyncratic risk can be eliminated through diversification and hence place no premium for idiosyncratic risk.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.