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hi i have a confusion about what conclusion I can draw regarding the pricing from the Capital market line and security market line.

As far as I know, if an asset that is lying below the SML is overpriced while above the SML is underpriced, which makes sense to me. However, why can't I draw such conclusion from the CML?? I guess it may because one is measuring beta while the other concerns standard deviation... What does "fairly-priced" mean??? Do we only need to concentrate on systematic risk (since it reflects from SML) on pricing??

Thank you!

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First understand that CML shows relationship between portfolio expected return and standard deviation, while SML shows relationship between a stock expected return and beta.

Any portfolio above CML is not achievable. It means you can not create portfolio that will provide you higher return for a given risk than what is available on CML. And investor will never choose any portfolio below the CML because he can always get higher return by choosing portfolio on CML for a given risk.

Further, CAPM only provide risk premium for systematic risk only because it assumes idiosyncratic risk can be eliminated through diversification and hence place no premium for idiosyncratic risk.

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  • $\begingroup$ @JackyLau if You donot know why SML consider beta instead of standard deviation, you may post it in the comment. Here, I assumed you know about this fact. $\endgroup$ – Neeraj Feb 17 '16 at 9:21
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    $\begingroup$ is it because the unsystematic risk can be diversified in a portfolio??? So we just consider the market risk in SML $\endgroup$ – jackycflau Feb 22 '16 at 8:20
  • $\begingroup$ @JackyLau You are right. $\endgroup$ – Neeraj Feb 22 '16 at 8:46

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