A CFA candidate is asked to distinguish between the Capital Market Line (CML) and the Security Market Line (SML). Which statement correctly describes a key difference between the two?
- AThe SML has a steeper slope than the CML because it captures unsystematic risk
- BThe CML uses total risk (standard deviation) and applies only to efficient portfolios, while the SML uses systematic risk (beta) and applies to all assets and portfolios
- CThe CML applies to all individual assets, while the SML applies only to efficient portfolios
- DThe CML and SML both use beta as the relevant risk measure, but differ in their intercepts
Show answer & explanationAnswer & explanation
Correct answer: B. The CML uses total risk (standard deviation) and applies only to efficient portfolios, while the SML uses systematic risk (beta) and applies to all assets and portfolios
The CML plots expected return against total risk (standard deviation) and applies only to efficient portfolios that combine the risk-free asset with the market portfolio; the SML plots expected return against systematic risk (beta) and applies to any individual asset or portfolio, whether efficient or not.
Why the other options are wrong
- A. Neither line captures unsystematic risk; SML relates only to systematic risk (beta).
- C. This reverses the correct applicability of the two lines.
- D. The CML uses standard deviation, not beta, so this is incorrect.
CML vs. SML
The Capital Market Line relates expected return to total risk for efficient portfolios; the Security Market Line relates expected return to systematic risk (beta) for any asset or portfolio.
- CML: x-axis is standard deviation, applies only to efficient portfolios
- SML: x-axis is beta, applies to all assets/portfolios
- SML is the graphical representation of CAPM
Memory trick: Capital line for the efficient crowd, Security line for everyone