Hello all,
Can you please explain this to me?
As per capital market theory, correctly priced individual assets can be plotted on
a) CML or CAL
b) SML
C) SCL
OA is B. Why is A wrong? Can someone please explain this to me? I am not sure what the term “correctly priced” means. I would really appreciate any help.
Thanks
On a graph of expected return vs. standard deviation of returns, a CAL is a line running through the point for the risk-free asset and the point for a given risky asset; there is a CAL for every risky asset. Thus, every asset, whether correctly priced or not, will plot on at least one CAL: it’s own.
Correctly priced assets will plot on _ the _ CML (the CAL with the highest Sharpe ratio) and on _ the _ SML.
I wrote an article on CAL vs. CML vs. SML that may help: http://financialexamhelp123.com/cal-vs-cml-vs-sml/.
Thank you for your response, S2000magician. I did go through the excellent article you have written. Can you please let me know what we mean by “pricing” ? Does it mean determining the variance of the return of the asset?
However, if so, I read in the curriculum (Chapter - Portfolio Theory - II ; EOC question #14) that total variance = systematic variance + non-systematic variance, but total variance is not equal to total risk. Hence, if pricing means determining the variance, then why is total variance not equal to total risk? I am a bit confused.
Moreover, there is also another related question that I thought of discussing for the benefit of all of us: why is non-systematic risk not “priced”? I didn’t quite understand this. If you can point me to an article or explain this, it will be really helpful.
I would appreciate your helping me. Thanks in advance.
Pricing means determining the price at which an asset should sell. When we say that a certain risk is priced or another risk is not priced, we’re being sloppy in our language; what we mean is that the price of the asset includes an adjustment for a particular risk (when that risk is priced) or fails to include an adjustment for a particular risk (when that risk is not priced).
For example, the price of a risky bond will generally be lower than the price of a comparable, risk-free (e.g., Treasury) bond. The price of the risky bond has been adjusted (downward) to compensate the buyer for the additional risks that he accepts when buying the risky bond.
As for the total variance not being the same as total risk: I’d have to see the entire write-up to know exactly how they meant that. Variance of returns, or standard deviation of returns, is not equal to risk; it’s merely a way to attempt to measure risk; like most attempts to measure risk, it’s imperfect.
The reason that nonsysematic risk is not (or, better said, should not be) priced is that in a well diversified portfolio that risk will have been diversified away. I’m not willing to pay you to take a risk that you can avoid taking; if you’re stupid enough not to diversify it away, that’s your problem, not mine.
Thank you so much for your reply, S2000magician. I have two follow-up questions, if you don’t mind, on your response:
#1 (I did google search for measuring risk, but I couldn’t find it) – I know that you have mentioned that standard deviation of the return is one way of measuring risk, what are other ways of measuring risk? Just out of curiosity.
#2 - I know that you have mentioned that the investor shouldn’t pay the investment manager for unsystematic risk. Your point makes sense. However, why is it that one of the limitations of the CAPM, as mentioned in the curriculum, is that CAPM measures only systematic risk and that tests of the CAPM show that asset returns are not determined only by systematic risk. If non-systematic risk should not be compensated, then why is this a limitation. I was a bit confused while reading the literature. Can you please help me?
Thanks in advance.
The correctly priced individual assets are plotted on SML i.e. security market line . On SML there are no undervalued or overvalued assets . There are fairly valued assets only . CAL is a tradeoff between risk free asset and risky asset.
My pleasure.
Three that show up in the CFA curriculum (at Level III) are lower semideviation, value at risk (VaR), and tail VaR.
I’ve never seen anyone say, specifically, that CAPM should be used only for well-diversified portfolios. However, there is a ratio used to compute risk-adjusted returns called the Treynor ratio; it’s similar to the Sharpe ratio, except that it has β in the denominator, rather than σ. Whenever they discuss Treynor, they’re explicit that it should be used only for well-diversified portfolios. Perhaps they should say the same thing about CAPM.
You’re quite welcome.
Hello S2000magician,
I think I misconstrued what’s in the book. (I read your response, CFAI and this link(http://www.columbia.edu/~ks20/FE-Notes/4700-07-Notes-CAPM.pdf) again, They are trying to say that CAPM can be applied any security – diversified or non-diversified. But, its β will measure only systematic risk because as you said, non-systematic risk shouldn’t be compensated.
On the other hand, CML can only be applied to diversified portfolios. Moreover, CML will tell us total risk, not just systematic risk.
Do you think my understanding is correct? I would really appreciate your response.
Thanks in advance.
Hello S2000magician,
I am sorry for bumping this thread. Could you please confirm my understanding? I would really appreciate your response.
Thanks