Capital Market Line

Definition

The Capital Market Line (CML) is a graphical representation that illustrates the relationship between the expected return and risk (as measured by standard deviation) of efficient portfolios that combine both risky assets and the risk-free asset. It is derived from the Capital Asset Pricing Model (CAPM) and shows how an investor can achieve optimal returns by diversifying their portfolio with the inclusion of the risk-free asset, typically represented by government securities.

5 Must Know Facts For Your Next Test

1. The CML starts at the risk-free rate on the y-axis and extends upwards to the right, representing increasing levels of risk and expected return.
2. All points on the CML represent efficient portfolios that maximize return for a given level of risk.
3. The slope of the CML is determined by the market risk premium, which is the difference between the expected return of the market and the risk-free rate.
4. Investors can create portfolios along the CML by combining different proportions of a risk-free asset and a market portfolio of risky assets.
5. Portfolios that lie above the CML are considered unattainable as they provide a higher expected return for a given level of risk than is feasible.

Review Questions

• How does the Capital Market Line illustrate the relationship between risk and expected return in portfolio management?
  • The Capital Market Line shows how efficient portfolios that combine risky assets and a risk-free asset can achieve optimal returns. As you move along the CML, you can see how expected returns increase with higher levels of risk. This illustrates to investors that by diversifying their investments into both risky and risk-free assets, they can create portfolios that yield better returns without taking on excessive risk.
• In what ways does the slope of the Capital Market Line influence investment decisions?
  • The slope of the Capital Market Line represents the market risk premium, indicating how much additional return investors can expect for taking on additional risk. A steeper slope suggests a higher market risk premium, which can encourage investors to take on more risk in hopes of higher returns. Conversely, if the slope is less steep, it may signal lower expected returns for increased risk, leading investors to reconsider their asset allocation strategies.
• Evaluate how deviations from the Capital Market Line affect investment portfolio performance and strategy.
  • When portfolios fall above or below the Capital Market Line, it indicates inefficiency in those investments. Portfolios above the CML imply they are providing higher returns for less risk than what is theoretically possible, suggesting either mispricing or exceptional management. Conversely, portfolios below the CML indicate underperformance, where investors are not being compensated adequately for their level of risk. This understanding encourages investors to reassess their strategies to align their portfolios with efficient frontiers represented by the CML.

Related terms

Efficient Frontier: A curve that represents the set of optimal portfolios that offer the highest expected return for a defined level of risk.

Risk-Free Rate: The theoretical rate of return on an investment with zero risk, often represented by short-term government bonds.

Sharpe Ratio: A measure used to evaluate the risk-adjusted return of an investment, calculated by subtracting the risk-free rate from the portfolio's return and dividing by the portfolio's standard deviation.