Capital Market Line (CML): What Does it Represent?
The capital market line (CML) is the tangent line that extends from the point of the risk-free asset to the feasible region for risky assets. The tangency point (denoted as M) is representative of the market portfolio. It is called so because all rational investors (minimum variance criterion) must hold their weights in the market portfolio in the same proportion as their risky assets. Let’s find out more about the Capital Market Line.
Capital Market Line (CML): All You Need to Know
What’s the history of the Capital Market Line?
Harry Markowitz and James Tobin are generally considered as the pioneers of mean variance analysis. In 1952, Markowitz identified the efficient frontier of optimal portfolios. In 1958, James Tobin included the risk-free rate to modern portfolio theory. The Capital Asset Pricing Model (CAPM) was developed by William Sharpe during the 60s. Harry Markowitz, William Sharpe and Merton Miller were awarded the Nobel Prize for Economics in 1990 for their work in this field.
What Is the Capital Market Line (CML)?
The capital market line (CML) is a representative of portfolios that have an ideal and optimal combination of risk with return. Capital asset pricing model (CAPM), is used to demonstrate the risk vs return trade off within efficient portfolios. 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. Under CAPM, all investors get to choose a specific position on the capital market line, in equilibrium, by borrowing or lending at the risk-free rate. This is done in order to maximize the returns for the given risk level.
Portfolios that fall on the capital market line (CML) tend to perform the best (at least in theory) because of the optimized risk/return relationship. The capital allocation line (CAL) makes up the allotment of risk-free assets and risky portfolios for an investor. The CML is nothing but a special case of the CAL where the market portfolio takes the place of the risk portfolio. The CML’s slope is also known as the Sharpe ratio of the market portfolio. Investors should buy the assets if the Sharpe ratio is above the CML and vice versa.
What makes CML different?
CML includes risk free investments and that makes it distinctly different from the slightly more popular efficient frontier.
What is a tangency portfolio?
A tangency portfolio is the most efficient type of portfolio and it is found at the interception point of CML and the efficient frontier.
What is the Capital asset pricing model (CAPM)?
The CAPM is the line that performs the task of connecting the risk-free rate of return with the tangency point on the efficient frontier of optimal portfolios that offer the highest expected return for a defined level of risk, or the lowest risk for a given level of expected return. This line usually contains portfolios that provide a great trade off between expected returns and risk.
The market portfolio can be found at the tangency point of the risky assets. Under the assumptions of mean-variance analysis – that investors seek to maximize their expected return for a given amount of variance risk, and that there is a risk-free rate of return – all investors will select portfolios that lie on the CML.
What is Tobin’s Separation Theorem?
Tobin’s Separation Theorem states that you can separate the problem into first finding that optimal combination of risky securities and then deciding whether to lend or borrow, depending on your attitude toward risk. It then showed that if there’s only one portfolio plus borrowing and lending, it’s got to be the market. Less risk averse investors will prefer portfolios higher up on the CML, with a higher expected return, but more variance. By borrowing funds at the risk-free rate, they can also invest more than 100% of their investable funds in the risky market portfolio, increasing both the expected return and the risk beyond that offered by the market portfolio.
What are the differences between the Capital Market Line and the Security Market Line?
The CML is often confused with the Security Market Line (SML). However, this is something every investor should avoid. The SML is nothing but a derivative of the CML. While the CML shows the rates of return for a specific portfolio, the SML does the job of showing the expected returns of individual assets, along with the market’s risk and return at a given time. And while the measure of risk in the CML is the standard deviation of returns (total risk), the risk measure in the SML is systematic risk, or beta. Fairly priced securities are plotted on both the CML and the SML. Securities that plot above the CML or the SML generate returns that are too high for the given risk and tend to be underpriced. Securities that plot below CML or the SML generate returns that are extremely low for the risk associated with them and end up being overpriced.
E(Rp) = Rf + σp ((Rm – Rf) / σm)
E(Rp) = Expected return of a portfolio
Rf = Risk free rate of return
σp = Standard deviation of a portfolio
σm = Standard deviation of market
Rm = Market rate of return
Let’s take this example: Find out the expected return of a portfolio if the market standard deviation is 23% and risk free rate is 4%. The market return is 12% and the standard deviation of portfolio is 5%.
E(Rp) = Rf + σp ((Rm – Rf) / σm)
= 4 + 5 ((12 – 4) / 23
= 4 + 5*0.35
= 4 + 1.75
So that was a brief look into what Capital Market Line (CML) is. Hopefully, you have a better idea of the concept and you will be able to use it to analyse your potential investments better. Happy Investing!