CFA Practice Question

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CFA Practice Question

The security market line (SML) ______

A. is just another name for the CAPM.
B. shows the risk-return relationship of the CAPM in well-functioning markets.
C. is kinked when there is borrowing at rates higher than RF.
D. is a graphical depiction of the CAPM.
Correct Answer: D

The SML is the graphical representation of the CAPM, not the same thing as the CAPM. It is not dependent on the markets functioning well. The SML is not affected by different borrowing rates.

User Contributed Comments 7

User Comment
examinee B is correct though. SML is kinked when borrowing rates are higher than RF.
phillip no the shape of the SML is not affected by borrowing rate.
0is4eva One of the first assumptions of the CAPM is that investors can borrow and lend any amount at the risk-free rate. In reality, however, investors can probably not lend any amount at T-bill rate because they must pay a premium when borrowing. This shows on the CML! The differential has the effect that two lines will go to the efficient frontier: from RFR for lending and from the intersection of the higher rate for the borrowing part. The CML will thus be made up of a straight line from RFR to the first point of tangency, a curved line until it reaches the second point of tangency, and from this point follow the straight line intersecting with the borrowing rate (on the y-axis). The SML is not affected by different borrowing rates.
SanderLin What B mentions about is the CAL(Capital Allocation Line)
danlan2 C: nice relationship between SML and CAPM
achu Sander Lin's onto it- the graph with borrowing above Rf rates is the CML (Capital market line). Strictly speaking, that curve has a straight line + curved line + straight line with flatter slope; because it includes the curved part I'm not sure we could properly still call it kinked. C is the best answer in any event.
ascruggs92 CML line is kinked, not SML. Leverage (borrowing) to increase returns on a security level is done by the company itself, so borrowing wouldn't kink the line, it would move it based on how the company's borrowing changes the risk of investing in it.
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