The similarities between SML and CML include all of the following except measures on the y-axis. measures on the x-axis. straight line. risk-free asset used
The correct answer and explanation is:
The correct answer is measures on the x-axis.
Explanation:
The Security Market Line (SML) and the Capital Market Line (CML) are both graphical representations used in modern portfolio theory, particularly related to the Capital Asset Pricing Model (CAPM). While they share significant similarities, their key distinction lies in what they measure on the horizontal (x) axis.
The Capital Market Line (CML) depicts the expected return for efficient portfolios depending on their level of total risk, which is measured by standard deviation (σ) on the x-axis. It represents the optimal combinations of the risk-free asset and the market portfolio, showing the highest return achievable for any given level of total risk for efficient portfolios.
The Security Market Line (SML), on the other hand, plots the expected return for any asset or portfolio (whether efficient or not) against its level of systematic risk, which is measured by beta (β) on the x-axis. Beta quantifies an asset’s sensitivity to market movements and is considered the relevant risk for diversified investors, as unsystematic risk can be diversified away.
Let’s look at the other options, which are indeed similarities:
- measures on the y-axis: Both the SML and the CML measure expected return on the vertical (y) axis.
- straight line: Both lines are depicted as straight lines under their respective assumptions. The CML connects the risk-free rate to the market portfolio, and the SML is derived from the linear relationship predicted by CAPM.
- risk-free asset used: Both lines incorporate the risk-free rate. The CML originates at the risk-free rate on the y-axis (representing a portfolio with zero risk and the risk-free return), and the SML’s y-intercept is the risk-free rate.
Therefore, the measures on the x-axis represent a fundamental difference, not a similarity, between the SML and the CML.