Introduction
The business world has changed due to change and advisement of technology. The share market is among the most dynamic fields that have been impacted by the demand and supply force (Adelaja, 2015). Investors need to clearly understand the market force in order to make the best investment that can yield great outcome.
The investors uses analysis portfolio which include stock analysis on an individual basis and for the entire portfolio which is crucial when making investment decisions since investors expected returns are only possible when the market is rising or during the growth of an economy. The investors should have complete ideas and it should be readily available.
Market analysis is immense concept that uses varieties of other approaches such as capital asset pricing model (CAPM), capital market line (CML) and security market line (SML).
Security Market Line (SML)
SML is also known as characteristic line. It is a graphical that represents a market‘s risk and return in a specified time. It is used as a graphical representation for capital asset pricing model (CAPM). SML helps investors to determine whether the security undervalued or overvalued. They determine this by analyzing the expected return on whether it is above the security market line, if is the price is under priced and if the expected return is below security market line it is considered to be over priced.
The equation for SML is
Where;
E [RI] =RF+ (E [RM]-RF) I
E [RI] is stock I’s expected return.
E [RM] is market’s expected return.
RF is the risk-free rate of return.
I is stock I’s systematic risk.
Capital Market Line (CML)
CML shows the rates of return that depends on risk free rates of returns and the level of risk for a given portfolio. CML assumes that any investor can either lend or borrow unlimited amount at risk free rate, they lend at a lower rate as compared to their borrowing. The investors choose any position on capital market line in the equilibrium either by borrowing or lending at the risk free rate which helps to maximize returns in a given risk level (Donohue, 2015). Investors usually invest in either risk free assets or combination of it with the portfolio of the market depends on the risk free (Girard, 2007). Investors buy assets when the Sharpe ratio is above capital market line and sell them when the Sharpe ratio is below CML.
CML equation E [Ri] = (E [Rm]-Rf)) Ói
Óm
Where;
E [Ri] is stock I’s expected return.
E [Rm] is market expected return.
Rf is the risk free rate of return.
Ói is stock I’s total risk.
Óm is the market total risk.
Difference between security market line and capital market line
SML shows the relationship between risk and return. It is basically a graphical representation of capital asset pricing model (CAPM)
E (Ri) Undervalued stocks
E (Rm) M
RF Overvalued stocks
0 SML line is used as a tool that determines whether an asset that is being considered for a portfolio gives a reasonable expected return for risk. Beta coefficient measures the risk factors of the security market line that measures the systematic risks only (Kuhle, 2009).
CML is used to measure the risk which is standard deviation of return; therefore it measures the total risk. Standard deviation is not the only risk measurement because there is inflation risk, currency variation risk and reinvestment risk in real market.
Capital market line
Expected ■M Efficient Frontier
Return
Rf
Standard DeviationA capital market line graph defines efficient portfolios while security market line defines both efficient and non efficient portfolio.
Security market line is used to determine individual stock risk or return while capital market line is used to find the risk or return for efficient portfolios.
When calculating returns and the expected return of a portfolio using CML, t is shown along the y axis while in SML the return of securities is shown along the Y axis.
CML is used to determine market portfolio and risk free assets while SML is used to determine security factors.
Security market line slope represents the market risk premium while capital market line slope represents market portfolio Sharpe ratio.
SML is a tool that is used to identify the appropriate expected securities return while CML tool is used to identify the appropriate asset allocation, percentages allocation to the risk free assets and to the market portfolio for the investors.
Security market line is mostly used by investors to evaluate the security of inclusion in an investment portfolio in determining whether the security offers a favorable expected return against its level of risk while capital market line is used by investors to maximize return at a given level of risk.
SML is used to compare security of equal risk and help the investors to identify which one offers a great expected return against the level of risk while CML tries to maximize expected rate of return for all investments.
Capital market line is considered to be the most effective when dealing with risk factors measurement. SML cannot be used for isolation purpose since the expected return rate over risk free return rate is not considered as one and only reason for decision making related to investment. This is the reason why CML is the best portfolio to be used. (McLaney & Atrill, 2016).
Security Market Line is used to show the expected returns of individual assets unlike capital market line.
When measuring risk factors, capital market line is considered superior than security market line.
Capital market line has a higher Sharpe ratio as compared to security market line. Its slope is sharper.
Security Market Line is flexible since its slope can be changed while capital market line
Minimum variance portfolios
Minimum variance portfolio is defined as an investment portfolio that helps the investors to minimize the level of risk. It allocates sums to different financial securities and assets that when captured together; reduce the volatility of the portfolio.
Most of the companies are running investment funds that base their strategy on minimum variance optimization (Johnson, 2008; Keefe, 2008).
Importance of minimum variance portfolio
It helps to determine the lower bond of the efficient frontier. Some portfolios on the investment opportunities set to the right and below the minimum variance portfolio, they are inefficient. This means that these portfolios have the same level of risk and a high return. There is no rational investor that would be interested to invest in portfolio which is below minimum variance portfolio (Scherer, 2011).
Minimum variance portfolio is important to investors since it maximizes the returns and at the same time it minimizes risk which helps them to succeed in their investment.
Minimum variance portfolio assigns weight to assets in a way that the portfolio risk is optimized. It helps to lower the risk out of all mean variance efficient portfolios which is independent of expected return.
It is important in investment since it is used by investors who do not want to take large risk.
Investors can easily shift from efficient portfolio which is also known as highest expected returns for a given risk to a minimum variance approach.
Minimum variance portfolio has the lowest risk out of all mean variance efficient portfolios and it does not depend on expected returns.
Minimum variance portfolio is important because its performance is better than any other type of mean variance efficient portfolio. It is also has a minimal impact from the criticism from modern portfolio theory since it optimize the independent from expected returns forecast which is mostly the major source of estimation errors.
Investors benefit from minimum variance portfolio since it has an increasing risk aversion among market participants stimulates creation of financial products which has a manageable volatility.
Minimum variance portfolio is important since it helps investors to determine the degree of investment returns whether it is below or above average. Therefore, it helps them to identify the best investment which will give them greater returns.
Minimum variance portfolio is important when investors want to maintain low correlation between different investments (Clarke, Silva, & Thorley, 2011)
In minimum variance portfolio, the investors are able to invest in different investments that do not respond the same in external market development.
It is important to investors since they are able to mix a set of volatile securities which help them to hedge against loses while maximizing earnings.
Capital asset pricing model equation (CAPM)
CAPM is used to show the relationship between expected risk and systematic risk for assets such as stocks. It helps investors to determine the cost of equity for risky individual securities or portfolios (Gaffney, 2017).
Benefits of capital asset pricing model equation over other equations
Capital asset pricing model equation has remained its popularity for over forty years since it has various advantages than the other equations used to determine the rate of return. It only considers systematic risks which reflect the reality that diversified portfolios have essentially excluded all unsystematic risk that may arise from individual asset investment characteristics (Watson, 2007) CAPM method helps to determine a specific discount rate for a project as compared to other equations such as WACC.
It shows the relationship between required rate of return and systematic risks that has been subjected to frequent empirical research and testing.
It helps to determine the discount rate that can be used in investment appraisal.
It is considered to be a better method for calculating the cost of equity than the dividend growth model since it considers the level of systematic risk relative to the stock market as a whole for a company.
CAPM equation helps investors to make better decisions on investment as compares to other methods such as WACC.
CAPM is simple and easier to use while calculating rate of return as compared to other equations. It shows the relationship between the rate of return and risk. Its calculations are simple which can be easily stressed tested in order to determine the range of possible outcomes that can provide confidentiality around the required rate of return.
CAPM has an objective nature that helps to estimate the cost of equity that the model can yield.
Unlike other models, capital asset pricing market can be used as an analytical tool kit.
In CAPM the investors’ expectations is assumed to remain the same over a given period of time. In this method, it is assumed that the investors will not incur transaction fees and taxes charge hence it remains popular in determining the rate of return as compared to other equations.
Capital assets pricing model is used mostly by financial analyst and investor determining the rate of return from several investment.
When a company’s business mix and financing has a contradiction with the current business, other return equation such as WACC cannot be used while CAPM can be easily employed. Therefore capital assets pricing model equation is more superior to other methods since it provides discount rates to be used in an investment appraisal.
Every investor holds the same portfolio in CAPM as compared to other equations.
In diversified portfolio, CAPM helps investors to access both systematic and unsystematic risk in the investment that they are willing to invest on. Therefore it helps investors to understand the sector they should diversify their investment in.
Reference
Adelaja, T. 2015 basic financial accounting
Clarke, R., De Silva, H., and Thorley, S. (2011). “Minimum Variance Portfolio Composition,” Journal of Portfolio Management 37(2), 31–45.
Donohue, c. 2015 foundation of financial risk
Gaffney, C. 2017 Is CAPM a good method to calculate cost of equity? Retrieved from www.pocketsense.com/camp-good-method-calculate-cost-equity-1618.html
girard 2015 trading volume and market volatility: developed versus emerging stock markets
Johnson, S. (2008, September 15). Magic formula defies all the rules. The Financial Times, p. 3.
Keefe, J. 2008. How to play safe before the Next Big Thing. The Financial Times.
Mclaney & Atrill 2016 accounting and finance: an introduction 8th edition
Retrieved from http://www.unigestion.com/DocsContainer/00116692.PDF
Scherer, B. (2011). “A Note on the Returns from Minimum Variance Investing,” Journal of Empirical Finance 18, 652–660
Watson, D. 2007 corporate finance: principles and practice 4th edition