Investment Analysis

&
Portfolio Management

LECTURE 06
31/10/2022 Syed Muhammad Ali Raza
 Capital Market Line
The capital market line (CML) represents portfolios that optimally
combine risk and return. It is a theoretical concept that represents
all the portfolios that optimally combine the risk – free rate of
return and the market portfolio of risky assets.

Formula and Calculation of the Capital Market Line (CML)

Calculating the capital market line is done as follows:

Risk – return of possible portfolio

31/10/2022 Syed Muhammad Ali Raza

 Capital Market Line

The slope of a capital market line of a portfolio is its Sharpe Ratio. We know that the greater the returns of a
portfolio, the greater the risk. The optimal and the best portfolio is often described as the one that earns the
maximum return taking the least amount of risk.

31/10/2022 Syed Muhammad Ali Raza

 Capital Asset Pricing Model
Assumptions of CAPM

• Investors only need to know expected returns, variances, and covariances in order to
create optimal portfolio
• All investors have the same forecast of risky assets’ expected returns, variances, and
covariances.
• All assets are marketable, and the market for assets is perfectly competitive
• Investors are price takers whose individual buy and sell decisions have no effect on asset
prices.
• There is no friction to trading, such as taxes or transaction costs.

31/10/2022 Syed Muhammad Ali Raza

 Capital Asset Pricing Model
Implications of CAPM

Given these assumptions, there are four important implications of CAPM.

• Because all investors have the same expectations and all use mean-variance analysis, they
will identify the same risky tangency portfolio(market portfolio) and combine that risky
portfolio with their risk-free asset when creating their portfolio.
• Because all investors hold the same risky portfolio the weight of each asset must be equal
to the proportion of its market value of the entire portfolio.
• The security market line, which is the graph of the CAPM, describes the relationship
between the expected return and systematic risk for all assets, both individual securities,
and portfolios.
• Systematic risk, measured by beta, is the only risk priced by the market.

31/10/2022 Syed Muhammad Ali Raza