Capital Market Line

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 in the sense that it combines

the risky assets with the risk-free asset.

 The slope of the Capital Market Line(CML) is the Sharpe Ratio of the market portfolio.

 The efficient frontier 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 risk of the portfolio and moving down will

decrease the risk. Subsequently, the return expectation will also increase or decrease

respectively.

All investors will choose the same market portfolio given a specific mix of assets and the

associated risk with them.

 
ample of the Capital Market Line
Let us see an example.

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Suppose that 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%

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. It means that the capital market line represents different

combinations of assets for a specific Sharpe ratio.

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 the Capital Market

Theory is the Capital Asset Pricing Model.

Capital Market Theory seeks to price the assets in the market. Investors or Investment Managers

who are trying to measure the risk and future returns in the market often employ several of the

models under this theory.