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You are on page 1of 14

:

All the points on the Capital Allocation Line are combinations of

[a] The risk free rate

[b] A portfolio of risky assets

**Whether your overall portfolio is 10% invested in rf and 90 % in a risky portfolio
**

or the other way around depends on your preferences and risk tolerance /

objectives.

**Your CAL will be different from mine (has a different slope) because we have
**

different risk preferences and objectives.

**I may be more risk averse than you and invest 20 % in rf and 80 % in a risky
**

portfolio. Hence we will draw different CALs.

Your risky portfolio will be different from mine.

CML:

**If you impose a set of conditions on the CAL such as homogeneous expectations
**

with respect to E(r) and risk of asets across ALL MARKET PARTICIPANTS you

will get the CML.

the CML is a combination of the rf and the tangency portfolio (market portfolio). SML : .While the CAL is a combination of the rf and a risky portfolio which varies across individuals. Whether you invest 10 % in rf and 90 % in market portfolio depends again on indivifual risk preferences BUT the market portfolio is the same for EVERYONE. All points on the efficinet frontier are combinations of risky assets that generate the highest return for a given level of risk. the CML connects the rf asset with the risky (market) portfolio…hence all the points on this line segment are combinations of the rf and the market portfolio. if you can invest in risky assets and the rf asset : the efficient frontier is the CML. All the points on the CAL are combinations of the rf and a risky portfolio which varies from person to person according to his/her risk preferences. Remember. If you can only invest in risky assets : the efficient frontier is the upper portion of the minium variance frontier. There is another way to understand the CML : It is the efficient frontier in a universe where you can invest in risky stocks and the rf asset. All the points on the CML are combinations of the rf and market portfolio which is the same for each person.

The SML is a simple tool for determining whether an asset offers reasonable expected return for the systematic risk it entails. A security plotting above the SML is undervalued ( its return is higher than it should be given its systematic risk implying that its price is lower than it should be ) A security plotting below the SML is overvalued (its return is lower than it should be given its systematic risk implying that its price is higher than it should be ) Also remember : the risk measure used by CAL/CML is the standard deviation of asset returns while that used by the SML is the systematic risk .assets that have a less than +1 correlation). the kind of risk that cannot be diversified away by holding a portfolio of diverse assets (i.e. that expected asset returns are linearly related to systematic risk.Graphical representation of the notion embodied in the CAPM. This is due to the fact that investors need to be compensated for assuming more systematic risk. The greater the systematic risk (Beta) -> the greater the expected return to a risky asset.

.CML vs SML CML stands for Capital Market Line. and SML stands for Security Market Line.

whereas. Unlike the Capital Market Line. The CML determines the risk or return for efficient portfolios. The CML measures the risk through standard deviation. the return of the securities is shown along the Y-axis. While the Capital Market Line graphs define efficient portfolios. which helps to find the security’s risk contribution for the portfolio. Well. is a graphical representation of the market’s risk and return at a given time. the Capital Market Line is considered to be superior when measuring the risk factors. Beta coefficient determines the risk factors of the SML. The standard deviation of the portfolio is shown along the X-axis for CML. While calculating the returns. and the SML demonstrates the risk or return for individual stocks. which depends on risk- free rates of return and levels of risk for a specific portfolio. One of the differences between CML and SML. SML. is how the risk factors are measured. On the other hand.The CML is a line that is used to show the rates of return. the expected return of the portfolio for CML is shown along the Y.axis. the Security Market Line graphs define both efficient and non-efficient portfolios. the SML measures the risk through beta. Summary: . On the contrary. the Security Market Line shows the expected returns of individual assets. the Beta of security is shown along the X-axis for SML. for SML. Where the market portfolio and risk free assets are determined by the CML. which is also called a Characteristic Line. While standard deviation is the measure of risk for CML. all security factors are determined by the SML. or through a total risk factor.

To do this. Investors are wealth maximizers who select investments based on expected return and standard deviation. the higher your potential return should be to offset your increased chance for loss. The original assumptions were: 1. While the Capital Market Line graphs define efficient portfolios. is a graphical representation of the market’s risk and return at a given time. all security factors are determined by the SML. Originally there were nine assumptions. . Like all financial models. the model relies on a risk multiplier called the beta coefficient. This means that the more risk you take. which we will discuss later in this lesson. which depends on risk-free rates of return and levels of risk for a specific portfolio. 4. Where the market portfolio and risk free assets are determined by the CML. 2. CAPM calculates a required return based on a risk measurement. The Capital Market Line is considered to be superior when measuring the risk factors. SML.1. The CML is a line that is used to show the rates of return. 5. although more recent work in financial theory has relaxed these rules somewhat. 3. which is also called a Characteristic Line. Beta coefficient determines the risk factors of the SML. One tool that finance professionals use to calculate the return that an investment should bring is the Capital Asset Pricing Model which we will refer to as CAPM for this lesson. The Capital Asset Pricing Model In finance. one of the most important things to remember is that return is a function of risk. While standard deviation is the measure of risk in CML. the CAPM depends on certain assumptions. the Security Market Line graphs define both efficient and non-efficient portfolios.

Investors can borrow or lend unlimited amounts at a risk-free (or zero risk) rate. 2. they cannot influence prices. 6. 6. Are rational and risk-averse. Aim to maximize economic utilities (Asset quantities are given and fixed). i. Are broadly diversified across a range of investments. 8. Are price takers. All financial assets are fully divisible (you can buy and sell as much or as little as you like) and can be sold at any time at the market price. Have homogeneous expectations. Can lend and borrow unlimited amounts under the risk free rate of interest. All investors have the same expectations related to the market.. The quantities of all financial assets are given and fixed. 9. No investor's activities can influence market prices. 7. Trade without transaction or taxation costs. Assume all information is available at the same time to all investors. 9. Deal with securities that are all highly divisible into small parcels (All assets are perfectly divisible and liquid). There are no restrictions on short sales (selling securities that you don't yet own) of any financial asset. 3. . There are no transaction costs. 4. 4. There are no taxes. 3. OR 1. 8. 5. 7.2.e. 5.

Obviously. but any number is possible.75 and 1. For actual use. The Beta Coefficient Before we can use the CAPM formula.0 implies less risk than the market average. and results can be adjusted to overcome some of these assumptions. By definition. the beta coefficients of most companies can be found on financial websites as well as in electronic publications. The beta coefficients of individual companies are calculated relative to the market's beta. Most companies' betas fall between 0.0. A beta above 1. but CAPM still works well.0 implies a higher risk than the market average. since it would imply less risk than a 'risk free' investment. a negative beta would be highly unlikely. however. . some of these assumptions are not valid in the real world (most notably no transaction costs or taxes). You can do a quick search to find companies' beta coefficients. we need to understand its risk measurement factor known as the beta coefficient. and a beta below 1. including negative numbers.50. the securities market as a whole has a beta coefficient of 1.

HOW IT WORKS (EXAMPLE): Modern portfolio theory (MPT). In other words. WHY IT MATTERS: In finance and investing. and -.as mentioned above -. he must be compensated with a higher expected rate of return. The graph displays to investors the return they might possibly earn by assuming a . The assumption of risk aversion leads to the conclusion that in order to entice someone to take a larger risk.CAL' The capital allocation line (CAL). all things being equal. relies on the assumption that investors are risk averse.the assumption that investors are risk averse is an underpinning of modern portfolio theory. is a line created on a graph of all possible combinations of risk-free and risky assets. it is almost universally recognized that the relationship among all of the assets and liabilities in an investor's portfolio should be considered in order to build an "optimum portfolio" for that investor's particular level of risk -. There is evidence to support the idea that investors are basically risk averse.Risk Averse Share4 WHAT IT IS: Risk averse is an oft-cited assumption in finance that an investor will always choose the least risky alternative. People buy insurance on valuable assets.and this phenomenon is called modern portfolio theory. also known as the capital market link (CML). or else he won't do it. Capital Allocation Line – CAL What is the 'Capital Allocation Line . which is the theory behind why diversification works. modern portfolio theory is the formula that explains both why and how a portfolio should be diversified. People expect a higher yield on bonds that are lower in priority when it comes to repayment.

such as certain Treasury securities. The expected return (ER) of this portfolio is calculated as follows: ER of portfolio = ER of risk-free asset x weight of risk-free asset + ER of risky asset x (1. such as equities. the expected return would be 3% and the risk of the portfolio would be 0%. The slope of the CAL is known as the reward-to-variability ratio. The simplest example is a portfolio containing two assets: a risk-free Treasury bill and a stock. The entire set of investment opportunities includes every single combination of risk-free and risky assets. the portfolio expected return and risk calculations would be: ER of portfolio = (3% x 25%) + (10% * 75%) = 0.CAL' The CAL aids investors in choosing how much to invest in a risk-free asset and one or more risky assets. Thus. BREAKING DOWN 'Capital Allocation Line . These combinations are plotted on a graph where the y-axis is expected return and the x-axis is the risk of the asset as measured by standard deviation. Likewise. risk is calculated as: Risk of portfolio = weight of risky asset x standard deviation of risky asset In this example.certain level of risk with their investment. whereas capital allocation is the allotment of funds between risk-free assets. The question that needs to be answered for any individual investor is how much to invest in each of these assets.weight of risk-free asset) The calculation of risk for this portfolio is simple because the standard deviation of the Treasury bill is 0%. Constructing Portfolios With the CAL An easy way to adjust the risk level of a portfolio is to adjust the amount invested in the risk-free asset. Assume that the expected return of the Treasury bill is 3% and its risk is 0%.75% + 7. investing 100% into the stock would give an investor an expected return of 10% and a portfolio risk of 20%. Further. Asset allocation is the allotment of funds across different types of assets with varying expected risk and return levels. if an investor were to invest 100% into the risk-free asset. assume that the expected return of the stock is 10% and its standard deviation is 20%.5% = 8. and risky assets.25% Risk of portfolio = 75% * 20% = 15% . If the investor allocated 25% to the risk-free asset and 75% to the risky asset.

the CML is better than the efficient frontier because it considers the infusion of a risk-free asset in the market portfolio. However. the stock is not a good buy. Capital Market Line – CML The capital market line (CML) appears in the capital asset pricing model to depict the rates of return for efficient portfolios subject to the risk level (standard deviation) for a market portfolio and the risk-free rate of return. The value of this calculation is known as the Sharpe ratio. In the CAPM. The security market line (SML) represents this. The capital market line conveys the return of an investor for a . There are two components needed to generate a CAPM. if the price is lower than the market price. It is the intersection between returns from risk-free investments and returns from the total market.Slope of the CAL The slope of the CAL measures the trade-off between risk and return. A higher slope means that investors receive higher expected return in exchange for taking on more risk. the securities are priced.CML' The capital asset pricing model (CAPM) proves that the market portfolio is the efficient frontier. it is compared to the market price. BREAKING DOWN 'Capital Market Line . A stock is a good buy if the estimated price is higher than the market price. CML and the SML. The capital asset pricing model determines the fair price of investments. Once the fair value is determined. so the expected risks counterbalance the expected returns. However. The capital market line is created by sketching a tangent line from the intercept point on the efficient frontier to the place where the expected return on a holding equals the risk-free rate of return.

The line graphically depicts the risk top investors earn for accepting added risk. typical investors must keep the market portfolio leveraged or deleveraged to realize their desired risk. Based on this. It states that the best blend of risky assets in the market portfolio is determined without considering the risk-return preferences of the investors. Separation Theorem All investors have portfolios on the CML relying on the risk-return preferences. the efficient portfolio has to be the market portfolio. when combining a no-risk asset with a portfolio on the efficient frontier. . it is possible to assemble portfolios whose risk-return profiles are above those of portfolios on the efficient frontier. James Tobin included leverage to the portfolio theory by including in the analysis an asset that pays a risk-free rate. History In 1952. In 1958. the SML must be used. However. This result is Tobin’s Separation Theorem. William Sharpe developed the CAPM that exhibits assumptions. The capital market line permits the investor to consider the risks of an additional asset in an existing portfolio. In 1964.portfolio. Harry Markowitz wrote his doctoral dissertation titled Portfolio Selection that recognized the efficient frontier. Single assets and nonefficient portfolios are not depicted on the CML. The capital market line assumes that all investors can own market portfolios. the market portfolio and the CML are depicted without reference to the risk-return tradeoff curves of the investors. Alternatively. Locating the best portfolio for a specific risk tolerance level consists of two methods: finding the best blend of market securities that does not fluctuate with risk tolerance and then joining it with a suitable amount of money. However.

given a desired level of expected return.Modern Portfolio Theory – MPT Modern portfolio theory (MPT) is a theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk. but should be evaluated by how the investment affects the overall portfolio's risk and return. Likewise. The expected return of the portfolio is calculated as a weighted sum of the individual assets' returns. an investor can construct a portfolio with the lowest possible risk. an individual investment's return is less important than how the investment behaves in the context of the entire portfolio. According to the theory. it's possible to construct an "efficient frontier" of optimal portfolios offering the maximum possible expected return for a given level of risk. the portfolio's expected return would be: (4% x 25%) + (6% x 25%) + (10% x 25%) + (14% x 25%) = 8. MPT shows that an investor can construct a portfolio of multiple assets that will maximize returns for a given level of risk." published in 1952 by the Journal of Finance. If a portfolio contained four equally-weighted assets with expected returns of 4. BREAKING DOWN 'Modern Portfolio Theory . 6. This implies than an investor will take on more risk only if he or she is expecting more reward. Based on statistical measures such as variance and correlation.5% .MPT' A major insight provided by MPT is that an investment's risk and return characteristics should not be viewed alone. Portfolio Risk and Expected Return MPT makes the assumption that investors are risk-averse. This theory was pioneered by Harry Markowitz in his paper "Portfolio Selection. 10 and 14%. emphasizing that risk is an inherent part of higher reward. meaning they prefer a less risky portfolio to a riskier one for a given level of return.

It is possible to draw an upward sloping hyperbola to connect all of the most efficient portfolios. Because of the asset correlations. Portfolio A would be deemed more "efficient" because it has the same expected return but a lower risk. since there are six possible two-asset combinations with four assets. .5% and a standard deviation of 9. Harry Markowitz was awarded a Nobel prize for developing MPT.5% and a standard deviation of 8%. For example. This plot reveals the most desirable portfolios. Efficient Frontier Every possible combination of assets that exists can be plotted on a graph. and that Portfolio B has an expected return of 8.The portfolio's risk is a complicated function of the variances of each asset and the correlations of each pair of assets. an investor needs each of the four assets' variances and six correlation values. To calculate the risk of a four-asset portfolio.5%. the total portfolio risk. and this is known as the efficient frontier. assume Portfolio A has an expected return of 8. Investing in any portfolio not on this curve is not desirable. or standard deviation. is lower than what would be calculated by a weighted sum. with the portfolio's risk on the X-axis and the expected return on the Y-axis.

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