0
$\begingroup$

I am referring to the book, "William Sharpe et al, Investments, 6th Edition. I am trying to wrap my head around some lines from the book, pertaining to Security Market Line. It reads,

  • "Earlier it was established that the expected return of a portfolio is a weighted average of the expected returns of component securities, where the proportions invested are the weights. Therefore every portfolio plots on the SML because every security plots on SML. To put it more broadly, not only every security but also every portfolio must plot on the upward sloping straight line in a diagram with expected return on vertical axis and beta on horizontal axis. So efficient portfolios plot on both CML and SML, although inefficient portfolios plot on the SML but below CML"

I understand the first two sentences. A portfolio is a convex combination of the individual securities and hence I can imagine that a line that plots individual securities on a standard deviation-expected return plane will also contain the portfolio made out of the securities. What I can infer from the above paragraph is that efficiency and inefficiency has nothing to do with plotting of SML since all portfolios will lie on it. However, CML plots only efficient sets. Is this correct? I seem to have some issues with understanding the relationship. I would be great help if someone could help me with it. Thanks a lot!

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Browse other questions tagged or ask your own question.