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What is the Capital Market Line (CML)?
The Capital Market Line (CML) represents the risk–return relationship of efficient portfolios that combine the market portfolio with a risk-free asset. It is a key concept in Modern Portfolio Theory, illustrating the highest expected return available for any given level of risk.
Definition
The Capital Market Line (CML) is a straight line that shows the optimal trade‑off between risk (standard deviation) and expected return for efficient portfolios formed from a mix of the risk‑free asset and the market portfolio.
Key Takeaways
- Describes the risk–return profile of efficient portfolios.
- Originates at the risk‑free rate and extends through the market portfolio.
- Portfolios on the CML dominate all other portfolios with the same risk.
Understanding the Capital Market Line
The CML is derived from Markowitz’s Efficient Frontier when a risk‑free asset is introduced. It shows how investors can allocate capital between:
- A risk‑free asset (e.g., government securities)
- The market portfolio (a fully diversified portfolio of risky assets)
The line demonstrates that any efficient portfolio is a combination of these two assets. Investors choose positions along the CML based on their risk tolerance:
- Conservative investors allocate more to the risk‑free asset.
- Aggressive investors use leverage to invest more than 100% in the market portfolio.
Portfolios below the CML are inefficient because they deliver lower returns for the same amount of risk. Portfolios above the CML are unattainable under CAPM assumptions.
Formula
Expected Return = Rf + [(Rm − Rf) / σm] × σp
Where:
- Rf: Risk‑free rate
- Rm: Expected return of the market portfolio
- σm: Standard deviation of the market portfolio
- σp: Standard deviation (risk) of the portfolio
The slope of the CML is the Sharpe Ratio of the market portfolio.
Real-World Example
If the risk‑free rate is 3%, the market return is 10%, and the market’s standard deviation is 15%:
Sharpe Ratio = (10% − 3%) / 15% = 0.47
For a portfolio with 9% standard deviation:
Expected Return = 3% + (0.47 × 9%) = 7.23%
This expected return lies on the CML and represents an efficient mix of risk‑free assets and the market portfolio.
Importance in Business or Economics
The CML is essential because it:
- Defines the best possible risk‑return combinations for diversified investors.
- Helps portfolio managers determine optimal leverage or risk exposure.
- Forms the foundation of the Capital Asset Pricing Model (CAPM).
It reinforces the principle that diversification eliminates unsystematic risk, leaving only market risk.
Types or Variations
- Efficient Frontier: The CML becomes the upper boundary when a risk‑free asset is introduced.
- Security Market Line (SML): Related but different—plots individual assets based on beta, not total risk.
Related Terms
- Efficient Frontier
- Sharpe Ratio
- Market Portfolio
Sources and Further Reading
- CFA Institute: https://cfainstitute.org
- Modern Portfolio Theory Resources: https://investopedia.com
- Academic Finance Journals: https://jstor.org
Quick Reference
- CML shows optimal portfolios combining market and risk‑free assets.
- Slope equals market Sharpe Ratio.
- Portfolios on CML are always more efficient than those below it.
Frequently Asked Questions (FAQs)
How is the CML different from the SML?
The CML uses total risk (standard deviation) and applies to efficient portfolios. The SML uses systematic risk (beta) and applies to individual securities.
Can a portfolio lie above the CML?
Not under CAPM assumptions, portfolios above the line imply unrealistic risk‑return combinations.
Why is the market portfolio central to the CML?
Because it represents the optimal combination of all risky assets available in the market.
