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Definition

Capital Market Line

What is Capital Market Line?

The Capital Market Line describes strategies that blend return and risk ideally. It is a mathematical model that reflects all strategies that integrate the uncertainty returns of riskier investments effectively. 

Understanding Capital Market Line

According to the Capital Asset Pricing Model (CAPM), all investors would pick a stable state on the CML by borrowing or loaning at a risk-free rate, because this optimizes profit for particular riskiness.

The CML considers the risk portfolio to be a current market price. A line is created visually to connect the stock market with the uncertainty asset. The capital market line is shown here. Asset risk and expected return are proportionate to one another. The bigger the asset risk and projected gain, the faster the investor goes up the CML, and conversely.

Formula 

The formula below is utilized to draw the Capital Market Line correctly -

 

ERp = Rf + SDp * (ERm – Rf) /SDm

Where,

ERp = Expected Return of Portfolio

Rf = Risk-Free Rate

SDp = Standard Deviation of Portfolio

ERm = Expected Return of the Market

SDm = Standard Deviation of Market

Importance 

In principle, portfolios that lie on the CML, maximize the risk/return ratio. As a result, the Equation of the portfolio equals the height of the CML. In theory, investors would try to acquire securities if indeed the Sharpe ratio is higher than it and raise capital if the Equation is less than the CML.

Restrictions

  • The existence of complexity
  • Taxation and transaction expenses 
  • Global investor disparities
  • Disregards many forms of risks
  • The lack of risk-free assets
  • A fault in uncertainty rates

Practical Example

Assume that the current risk-free rate is 3% and the predicted market return is 15%. The market portfolio has a standard deviation of 12%.

Now consider two portfolios with varying Standard Deviations:

A has a 6% return.

B has an 18% return.

Calculation of Portfolio Expected Return A

Calculation of Portfolio Expected Return A

The ER(A) is 9%.

In Sentences 

  • The Capital Market Line (CML) is based on the capital market concept and the CAPM. 
  • The Capital Market Line portfolios optimize the risk-return ratio.

 

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