8/5/2019 Capital Market Line | A Matter of Course

A Matter of Course

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[FM] CML vs. SML

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We earlier wrote the Capital Market Line (CML) as:

which describes expected return from efficient portfolios.

Later in the class we extended this idea of expected return as comprising reward for waiting , and
reward for bearing risk to write the Security Market Line (SML) from the Capital Asset
Pricing Model (CAPM) as:

where,

where the only, but the key, difference was that instead of using standard deviation as a measure of risk
we used – sensitivity of change in return from a stock to change in the market – as the measure of
risk. (For those interested, a nice proof consistent with our discussion is here. )

Another important distinction between CML and SML is that while the former can be used only for
efficient/optimal portfolios, the la er can be used all assets, inefficient portfolios as well as efficient
portfolios.
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That is CML is like a subset of SML, or alternatively SML subsumes CML.

Before we can prove this result, however, we need another result – that market beta is a weighted
average of beta of individual securities. In this part of the post we establish the relationship for , and
in the next part we prove that SML implies CML.

Market beta is a weighted average of beta of individual securities

This result is easy to prove if we take our starting point as the result that market variance is a weighted
average of covariance of individual assets with the market (previous post), i.e.:

Dividing both sides by gives:

Using the intuition that is the sensitivity of change in a stock’s return to change in market return, that
is, it can be interpreted as the regression coefficient, we have the result that:

We can now substitute this formula for in the previous equation and write:

By definition market is (this is trivial, beta of the market represent change in the market when
market changes), we have our required result that:

Or, more succinctly, using the summation symbol:

Next we’ll use this result to show that SML implies CML – which brings us to our last lesson for this
module:

Moral of the Story 5: In the CAPM world, while CML describes expected return from efficient
portfolios SML describes expected return from individual stocks, inefficient portfolios as well as
efficient portfolios. SML implies CML.

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Wri en by Vineet

September 3, 2015 at 9:22 am

Posted in Capital Asset Pricing Model, Capital Market Line, Diversification, Security Market LIne

Tagged with Capital Asset Pricing Model, Capital Market Line, FM-2015-16, Portfolio Theory, Security
Market Line, Session 9

[FM] Capital Market Line

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At this stage, having introduced the new straight line efficient set, we are all but there to our final
destination. So, let’s step back a bit and try and understand the larger picture.

In the beginning was the efficient frontier. Markowi gave us that. Efficient frontier describes
the maximum possible expected return for any given amount of risk from the portfolio of available assets. Or
alternatively, the minimum amount of risk that one must live with for any given amount of expected return.
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As a first step, we moved from individual assets to portfolios that lay on the efficient frontier. When we
did that implicitly the x-axis (labeled as risk/standard deviation) then became the risk of the portfolio
(and not the risk of the individual assets). There should be no cause for this confusion, but no harm
emphasizing it nonetheless – the right risk to consider is the risk of the portfolio and not the individual
asset.

Moral of the Story 1: When we consider the efficient frontier the relevant quantities to consider
are portfolio risk and portfolio expected return.

Then, of course, Tobin came along and introduced a risk free asset in the Markowi world, and he said
we could ignore all other points on the frontier except the tangency one – because everybody would
hold some proportion of only the tangency portfolio (as all other points even on the envelope are
now inferior), and the line connecting the return from the risk free asset and the tangency portfolio
offers the best possible combinations of portfolio risk and expected return. Remember, the operative
word here is portfolio.

This gave us our revised efficient set as:

(Click on the figure to zoom.)

The equation of the new efficient set immediately follows (it’s a linear line with intercept at and
slope ) as:

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What is the tangency portfolio ?

Having said that all investors should hold the tangency portfolio , the next thing to understand is the
meaning of this tangency portfolio. By saying that all investors should hold , what we are essentially
saying is that investors would demand only combinations of portfolio and the risk-free asset.
(Holding any other risky portfolio other than is inefficient.) This is the demand side of the problem.
What is the supply side? The supply side is just all the assets that exist in the market.

And by now you would know enough of microeconomics to understand that equilibrium requires that
demand be same as supply. That is, assets demanded in the portfolio must exactly equal the supply
of each asset in the market. And the supply of each asset in the market is given by its market
capitalization. So, in equilibrium all assets must be held in in exactly the same proportion as their
market capitalization. That is, in percentage terms weight of assets in the total market capitalization and
in the portfolio must be the same.

Consider the case where you run your Markowi optimizer and find that that weight of a particular
asset, say is . Is that possible? Mathematically, of course, yes. But what about economically? Let’s
try and understand this.

Saying that the weight of an asset in the Markowi portfolio is is saying that no investor
wants to hold the asset. If no investor wants to hold that asset, but the asset exists in the market then
we have a state of disequilibrium. And what happens in a state of disequilibrium? Prices adjust. So, if no
wants to hold an asset, its price will drop. Once the price starts to drop its expected return:

will rise. As the price starts to fall, and expected return starts to rise, investors would start to find this
asset more a ractive. As its expected return rises even more, then when you re-run your
Markowi optimizer again, you’ll find that this asset has a non-zero weight in the tangency portfolio
. That is, all assets that exist in the market must be held. This brings us to another important lesson:

Moral of the Story 2: The tangency portfolio is nothing but the market itself!

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As another example consider a situation where the Markowi optimizer prescribes a weight of
for an asset whose market capitalization is . What happens in that case? Well, now you know how to
think about such disequilibrium situations. This is the case where the asset has more demand than
supply. When demand is more than supply, prices rise. As price rises, the expected return will fall. As
expected return falls, the Markowi optimizer will prescribe a lower weight to this asset and in
equilibrium the price and the market capitalization of the asset would adjust to make the demand
exactly equal supply. That is:

When one imposes equilibrium, the line passing through the tangency portfolio has a specific name and
it is called the Capital Market Line.

Note that at this stage, when we impose economic equilibrium, we have to necessarily assume that
everybody has the same information – things don’t quite work the same way otherwise. And this brings
us to the last moral of the story for today:

Moral of the Story 3: All efficient portfolios lie on the Capital Market Line.

Again, as in the case of the efficient frontier, the relevant quantities in the Capital Market Line are
the expected return and risk of efficient portfolios. All individual stocks and other inefficient portfolios,
however, would be anywhere below the efficient frontier, as say in the shaded portion of the graph
below (from your book; think of in the plot below as the equilibrium market portfolio):

CML with the Efficient Frontier (Click to zoom; Source: Brealey-Myers, 9th Ed.)

Wri en by Vineet

August 28, 2015 at 3:54 pm

Posted in Capital Market Line, FM, Portfolio Selection

Tagged with Bank, Capital Market Line, Equilibrium, FM-2015-16, Markowi , Session 8, Tangency
Portfolio, Tobin

[FM] Portfolio Selection with a Risk-free Asset

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For all his insights on the portfolio choice problem, somehow Markowi didn’t explicitly consider a
bank in the system. In principle, of course, one could have solve the problem by just adding one more
security in his set up. However, it turns out that having a bank in the system is not just a ma er of
adding one more security to the world – there is a bit more to it.

Let’s first consider how a Markowi -ian would handle this problem. A fan of Markowi would just
rerun the following optimization problem, but instead would consider assets instead of , i.e.
nothing much really changes:

So, we would need to rerun our optimization software and this will give us a new allocation of weights
to all the securities. Today, of course, the problem is hardly difficult (you can even do it in Excel). But is
it the best way to introduce a risk-free asset in the Markowi world?

James Tobin, a colleague of Markowi ’s at the Cowles Foundation in the ’50s (and another Nobel
Laureate) argued that it’s not. And brilliant as his device was, we can easily see its impact in a two stock
world.

In our familiar two stock world, let one of the assets be risk-free, such that it’s rate of return is known
‘today’ as with variance, of course, zero. Then, since of the assets is no more a random variable,
even the correlation between the two would also be 0. So, if in our set of equations:

we let we are left with:

That is, our Efficient Frontier in this case is simply a straight line connecting the rate of return from the
risk-free asset and the expected return from the asset , with slope If one could assume
that people could both borrow and lend at the same risk-free rate, , then we could even consider
negative weights on the risk-free asset, and extend the Efficient Frontier to the right (the “blue dots” in
the graph below). So, if an investor would extremely risk-loving he/she could borrow money from the
bank and invest it in the second risky asset.

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(Click on the graph to zoom.)

With this insight Tobin said that with the risk-free asset in the world in the asset Markowtiz-ian
world, we can just consider such straight lines emanating from the intercept on the ordinate (return from
the risk-free asset ) and connecting with all the points on Efficient Frontier. That is, he said, rather
than re-running the Markowi optimizer, let’s only consider following straight lines connecting the
Efficient Frontier:

(Click on the graph to zoom.)

That is, instead of considering just single assets, Tobin argued we could consider connecting straight
lines to efficient portfolios. And lines of the kind , and all such possibilities.
By now it should be clear that we have a new Efficient Frontier which is the line . So while
points lying to the left of the “blue dots” mean that some of the wealth is invested in the risk-free asset
and some in the portfolio (called the tangency portfolio), and points lying on the “blue dots”
represent the points where an investor has put all of one’s wealth in the tangency portfolio and then
some.

That is, as we see having a risk-free asset in the Markowi world changes everything. Instead of a
concave envelope superior to all other individual assets and inefficient portfolios, having a bank in the
world means that all investors should park all their weight only in combination of the risk-free asset and
the tangency portfolio.
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Another way of stating the same thing is to say that the line from to is the steepest, or
alternatively offers the maximum reward per unit of risk compared to any other point on the frontier.
That is, the slope of the line is more than slope of both lines and .

Financial market professionals have kinda made this idea their own and turned it into a measure of
performance to gauge the excess return per unit of risk from investment choices made by fund
managers. They call the slope of the lines emanating from and joining points on the efficient
frontier, like , and , as the Sharpe ratio.

Since the slope of the line is the highest, so is the Sharpe ratio of investment in the market
portfolio. Note that since Sharpe ratio is defined in terms of expected returns, ex-ante (or before-the-fact)
Sharpe ratio of investment in the market portfolio is the highest. So, for a given point, say, , on the
efficient frontier the Sharpe ratio is given as:

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This brings us to the second separation theorem in finance, and it goes by multiple names of Tobin/Two-
fund/Mutual-fund Separation Theorem. It’s important enough to warrant a formal statement:

Mutual Fund Separation Theorem: Each investor will have a utility maximising portfolio that is a combination
of the risk-free asset and a tangency portfolio . All risky portfolios other than the portfolio are
inefficient.

Note that all points to the ‘top’ of are una ainable. Our original Efficient
Frontier presented all possibilities giving maximum return for any given level of risk. Having a risk-free
asset implies that the line connecting the return from the risk-free asset and the tangency portfolio
dominates all other possibilities. This is the new efficient frontier.

And now we can get rid of the original concave envelope, and we are left with just the
line. And a quick Google Image search gives us this nice li le picture presenting different possibilities
combining the risk-free asset and the tangency portfolio:

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[Click on the figure to zoom; Source: Wikipedia]

Post-script

Needless to say, by definition, Sharpe ratio coincides with the slope of the line when the
investment manager chooses as the point on the frontier, i.e.:

Here is Nobel Laureate William Sharpe on the ratio that bears his name.

Wri en by Vineet

August 28, 2015 at 3:45 pm

Posted in Capital Market Line, FM, Portfolio Selection

Tagged with Bank, Capital Market Line, FM-2015-16, Markowi , Session 8, Tangency Portfolio, Tobin

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