A question from the book reads as follows:
the line depicting the risk and return of portfolio combinations of a risk free aset and any risky asset is the:
I.) security market line
II.) capital allocation line
III.) security characteristic line
the answer is II.
From the book, the CAL includes only efficient portfolios while the SML contains all portfolios (or assets) so it seems that for this question, where they say “any risky assets” the answer would be the SML. Thoughts?
A CAL runs through the risk-free asset and a given risky asset.
The SML runs through the risk-free asset and the market portfolio.
So an I confusing “efficient” with something else? The book says that the CML and CAL apply to efficient assets only, whereas, for example, the security market line is described as, “applying to any security, efficient or not.” I guess when the question states “any risky asset” I take that to mean “efficient or inefficient”.
Where do you see that the CAL applies only to efficient assets? That sounds weird.
Similarly, I don’t know what they mean by the SML applying to any security.
If I can see what you’re reading, I can probably decipher it.
Here is a screenshot from the ebook.
[screenshot removed by admin]
I see what they’re trying to say.
The market compensates an investor only for systematic risk, not for nonsystematic risk (because the investor can diversify away nonsystematic risk). Therefore, because a CAL (and the CML) uses total risk on the horizontal axis, it doesn’t make sense to draw a CAL through an inefficient portfolio; there are efficient portfolios with either the same risk and higher return, or the same retrn and lower risk. However, because the SML uses beta (systematic risk) on the horizontal axis, it makes sense to compare any portfolio (efficient or not) to the SML.
Their way of describing it certainly isn’t straightforward.
So wouldn’t the answer to the question be “SML” not “CAL”?
Also, as a side note, when they refer to “correctly priced individual assets” that means efficient assets, right?
No.
The SML goes through the risk-free asset and the market portfolio. Not just any old risky asset.
No. It means any asset which is priced according only to its systematic risk, not its total risk.