Capital Market Line

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.

All investors will choose the same market portfolio, given a specific mix of assets and the associated risk with them.

Capital-Market-Line.png

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Capital Market Line (wallstreetmojo.com)

Capital Market Line Formula

The Capital Market Line (CML) formula can be written as follows:

ERp = Rf + SDp * (ERm – Rf) /SDm

where,

We can find the expected return for any level of risk by plugging the numbers into this equation.

Example of the Capital Market Line

You can download this Capital Market Line Excel Template here – Capital Market Line Excel Template

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

Capital Market Line Example 1
  •  = 5% +5%* (18%-5%)/10%
  • ER(A) = 11.5%

Calculation of Expected Return of Portfolio B

Example 1.1
  • = 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 ModelCapital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more.

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.

Assumptions of the Capital Market

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Capital Market Line (wallstreetmojo.com)

Limitations

  • 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.

Conclusion

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 –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *