Capital Market Line (CML) Definition
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.
Capital Market Line Formula
The Capital Market Line (CML) formula can be written as follows:
- Expected Return of Portfolio
- Risk-Free Rate
- Standard Deviation of Portfolio
- Expected Return of the Market
- Standard Deviation of Market
We can find the expected return for any level of risk by plugging the numbers into this equation.
Example 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
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.
Assumptions of the Capital Market Theory
There are certain assumptions in the Capital Market Theory, which hold true for the CML also.
- Frictionless Markets – The theory assumes the existence of frictionless markets. This means that there are no transaction costs or taxes applicable to such transactions. It assumes that investors can smoothly conduct transactions in the market without incurring any additional costs.
- No Limits on Short Selling – Short selling is when you borrow securities and sell them with an expectation of the securities’ price going down. Capital Market Theory assumes that there are no limits on the usage of the funds received from short selling.
- Rational Investors – The Capital Market Theory assumes that investors are rational, and they take a decision after assessing risk-return. It assumes that the investors are informed and make decisions after careful analysis.
- Homogenous Expectation – Investors have the same expectations of future returns in their portfolio. Given the 3 basic inputs of the portfolio model for calculating future returns, all investors will come up with the same efficient frontier. Since the risk-free asset remains the same, the tangency point, which represents the Market Portfolio, will be the obvious choice of all investors.
- Assumptions – There are certain assumptions that exist within the concept of Capital Market Line. However, these assumptions are often violated in the real world. For example, the markets are not frictionless. There are certain costs associated with the transactions. Also, investors are usually not rational. They often make decisions based on sentiments and emotions.
- Borrowing/Lending at Risk-Free Rate – Theoretically, it is supposed that investors can borrow and lend without any limits at the risk-free rate. However, in the real world, investors usually borrow at a higher rate than the rate at which they are able to lend. This increases the risk or standard deviation of a leveraged portfolio.
The Capital Market Line (CML) draws its basis from the capital market theory as well as the capital asset pricing model. It is a theoretical representation of different combinations of a risk-free asset and a market portfolio for a given Sharpe Ratio. As we move up along the capital market line, the risk in the portfolio increases, and so does the expected return. If we move down along the CML, the risk decreases as does the expected return. It is superior to the efficient frontier because the ef only consists of risky assets/market portfolio. The CML combines this market portfolio with this market portfolio. We can use the CML formula to find the expected return for any portfolio given its standard deviation.
The assumption for the CML is based on the assumptions of the capital market theory. But these assumptions often don’t hold true in the real world. The Capital Market Line is often used by analysts to derive the amount of return that investors would expect to take a certain amount of risk in the portfolio.
This article has been a guide to what is Capital Market Line (CML) and its definition. Here we discuss the formula to calculate the capital market line along with assumptions and limitations. You can learn more about valuations from the following articles –