Relative to portfolios on the cml, any portfolio that plots above the cml is considered:

The Capital Market Line is a graphical representation of all the portfolios that optimally combine risk and return. CML is a theoretical concept that gives optimal combinations of a risk-free asset and the market portfolio. The CML is superior to Efficient Frontier because it combines risky assets with risk-free assets.

Inhaltsverzeichnis Show

Capital Market Line Formula
Example of the Capital Market Line
Capital Market Theory
Assumptions of the Capital Market Theory
Limitations
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The slope of the Capital Market Line(CML) is the Sharpe RatioSharpe Ratio, also known as Sharpe Measure, is a financial metric used to describe the investors’ excess return for the additional volatility experienced to hold a risky asset. You can calculate it by, Sharpe Ratio = {(Average Investment Rate of Return – Risk-Free Rate)/Standard Deviation of Investment Return} read more of the market portfolio.
The efficient frontierThe efficient frontier, also known as the portfolio frontier, is a collection of ideal or optimal portfolios that are expected to provide the highest return for the minimum level of risk. This frontier is formed by plotting the expected return on the y-axis and the standard deviation on the x-axis.read more represents combinations of risky assets.
If we draw a line from the risk-free rate of return, which is tangential to the efficient frontier, we get the Capital Market Line. The point of tangency is the most efficient portfolio. ·
Moving up the CML will increase the portfolio’s risk, and moving down will decrease the risk. Subsequently, the return expectationThe Expected Return formula is determined by applying all the Investments portfolio weights with their respective returns and doing the total of results. Expected return = (p1 * r1) + (p2 * r2) + ………… + (pn * rn), where, pi = Probability of each return and ri = Rate of return with probability. read more will also increase or decrease, respectively.

All investors will choose the same market portfolio, given a specific mix of assets and the associated risk.

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Source: Capital Market Line (wallstreetmojo.com)

Capital Market Line Formula

The Capital Market Line (CML) formula can be written as follows:

ERp = Rf + SDp * (ERm – Rf) /SDm

where,

We can find the expected return for any level of risk by plugging the numbers into this equation.

Example of the Capital Market Line

Suppose the current risk-free rate is 5%, and the expected market return is 18%. The standard deviation of the market portfolio is 10%.

Now let’s take two portfolios with different Standard Deviations:

Portfolio A = 5%
Portfolio B = 15%

Using the Capital Market Line Formula,

Calculation of Expected Return of Portfolio A

= 5% +5%* (18%-5%)/10%
ER(A) = 11.5%

Calculation of Expected Return of Portfolio B

= 5% +15% (18%-5%)/10%
ER(B) = 24.5%

The capital market line represents different combinations of assets for a specific Sharpe ratio. As we increase the risk in the portfolio (moving up along the Capital Market Line), the expected return increases. The same is true vice-versa. But the excess return per unit of risk, which is the Sharpe ratio, remains the same.

Capital Market Theory

Capital Market Theory tries to explain the movement of the Capital Markets over time using one of the many mathematical models. The most commonly used model in Capital Market Theory is the Capital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more.

Capital Market Theory seeks to price the assets in the market. Investors or Investment ManagersAn investment manager manages the investments of others using several strategies to generate a higher return for them and grow their assets. They are sometimes also referred to as portfolio managers, asset managers, or wealth managers. They may also be considered financial advisors in some cases, but they are typically less involved in the sales aspect.read more trying to measure the risk and future returns in the market often employ several of the models under this theory.

Assumptions of the Capital Market Theory

There are certain assumptions in the Capital Market Theory that hold for the CML.

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Source: Capital Market Line (wallstreetmojo.com)

Limitations

Assumptions – Certain assumptions exist within the concept of the Capital Market Line. However, these assumptions are often violated in the real world. For example, the markets are not frictionless. There are certain costs associated with the transactions. Also, investors are usually not rational. They often make decisions based on sentiments and emotions. ·
Borrowing/Lending at Risk-Free Rate – Theoretically, it is supposed that investors can borrow and lend without any limits at the risk-free rate. However, in the real world, investors usually borrow at a higher rate than the rate at which they can lend. It increases the risk or standard deviation of a leveraged portfolio

Conclusion

The Capital Market Line (CML) draws its basis from the capital market theory and the capital asset pricing model. It is a theoretical representation of different combinations of a risk-free asset and a market portfolio for a given Sharpe Ratio. It is superior to the efficient frontier because it only consists of risky assets/market portfolios. The CML combines this market portfolio with this market portfolio. As we move up along the capital market line, the risk in the portfolio increases, and so does the expected return. If we move down along the CML, the risk decreases, as does the expected return. We can use the CML formula to find the expected return for any portfolio given its standard deviation.

Analysts often use the Capital Market Line to derive the return amount that investors expect to take a certain amount of risk in the portfolio. The assumption for the CML is based on the assumptions of the capital market theory. But these assumptions often don’t hold in the real world.