MATRIC NO: 19/66MA028
COURSE CODE: FIN414
COURSE TITLE: INVESTMENT ANALYSIS
ASSIGNMENT: write short note on the following…
1. Security market line
The Security Market Line is derived from the capital market line. It is a graph that
shows the required return from any investment given its beta factor. Actual returns
from investments can be compared to the figure from the security market line to
determine whether that investment is under or overvalued.
2. Capital market line
The market portfolio does not include risk-free investments. However, risk free
investments (or at least investments with very low risk) are available to investors.
In practice, government bonds denominated in the domestic currency are classified
as risk-free investments.
Investors can choose to invest in a portfolio consisting partly of the market
portfolio and partly of risk-free investments. This returns us to the idea of a two
asset portfolio. A graph showing the risk and returns of different proportions of
investment in a risk free asset and an asset with risk (the market portfolio) would
be a straight line. This is called the capital market line.
A straight line can be drawn from the portfolio that is 100% risk-free (where the
line intersects the vertical axis) to touch the efficient frontier at a tangent. This will
be at the market portfolio M. An investor can select any portfolio on this line, such
as Portfolio P, to provide a mixture of risk-free investments and the market
portfolio investments.
The line that joins the risk free asset and the market portfolio M is called the
capital market [Link] capital market line (CML) shows all combinations of risk-
free investments and market portfolio investments that investors may select.
3. Efficient frontier
In theory, it would be possible to prepare a graph showing every possible portfolio
that investors might choose from the market as a whole, with the expected return
from the portfolio plotted on the y axis and the risk of the portfolio, measured as
the standard deviation of its expected returns, on the x axis.
The efficient portfolios all lie on the top edge. A line can be drawn through these
efficient portfolios, to obtain the efficient frontier of investment portfolios. A risk-
averse investor will always choose a portfolio on this efficient frontier.
4. Indifference curve
The next question is whether investors might choose any investment portfolio on
this efficient frontier, or whether there is any particular portfolio that will be
preferred by all investors, above all the other portfolios.
This question is addressed using the concept of indifference curves and investor
[Link]-averse investors are prepared to accept higher risk for a higher
investment return, but may also choose a lower expected return for lower risk. An
investor’s preferences for higher returns or less risk can be illustrated in a graph of
indifference curves.
This graph shows three indifference curves:
Curve 1 shows the combinations of risk and return that are of equal merit or
attractiveness to the investor. The investor will be indifferent about choosing any
portfolio that lies on this curve.
Similarly, Curve 2 shows the combinations of risk and return that are of equal
merit or attractiveness to the investor. The investor will be indifferent about
choosing any portfolio that lies on this curve. However, the investor will prefer a
portfolio on Curve 2 rather than a portfolio on Curve 1, because portfolios on
Curve 2 will offer a higher return for less risk than portfolios on Curve 1 (or lower
risk for the same return).
Curve 3 also shows the combinations of risk and return that are of equal merit or
attractiveness to the investor and the investor will be indifferent about choosing
any portfolio on this curve. However, the investor will prefer a portfolio on Curve
3 rather than a portfolio on Curve 2, because portfolios on Curve 3 will offer a
higher return for less risk than portfolios on Curve 2 (or lower risk for the same
return).
Rational investors will select a portfolio for investment that lies on an indifference
curve as far to the left on the graph as possible.
