Capital Market Line (CML)

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 The Equilibrium Return-Risk Tradeoff:

Given the previous analysis, we can now derive some predictions concerning equilibrium expected returns and risk. On an overall basis, we need an equilibrium model that encompasses two important relationships. 

  • The capital market line specifies the equilibrium relationship between expected return and risk for efficient portfolios. 
  • The security market line specifies the equilibrium relationship between expected return and systematic risk. It applies to individual securities as well as portfolios.
THE CAPITAL MARKET LINE:

The capital market line (CML) represents portfolios that optimally combine risk and return. Capital asset pricing model (CAPM), depicts the trade-off between risk and return for 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 will choose a position on the capital market line, in equilibrium, by borrowing or lending at the risk-free rate, since this maximizes return for a given level of risk. 

Capital market line (CML), depicts the equilibrium conditions that prevail in the market for efficient portfolios consisting of the optimal portfolio of risky assets and the risk-free asset. All combinations of the risk-free asset and the risky portfolio M are on the CML, and, in equilibrium, all investors will end up with a portfolio somewhere on the CML based on their risk tolerance.

Key Points:

  • The capital market line (CML) represents portfolios that optimally combine risk and return.
  • CML is a special case of the CAL where the risk portfolio is the market portfolio. Thus, the slope of the CML is the sharpe ratio of the market portfolio.
  • The intercept point of CML and efficient frontier would result in the most efficient portfolio called the tangency portfolio.
  • As a generalization, buy assets if sharpe ratio is above CML and sell if sharpe ratio is below CML.

The CML is shown as a straight line in Figure without the now-dominated Markowitz frontier. We know that this line has an intercept of RF. If investors are to invest in risky assets, they must be compensated for this additional risk with a risk premium. The vertical distance between the risk-free rate and the CML at point M in Figure  is the amount of return expected for bearing the risk of owning a portfolio of stocks, that is, the excess return above the risk-free rate. At that point, the amount of risk for the risky portfolio of stocks is given by the horizontal dotted line between RF and σM.
     
Therefore,

The slope of the CML is the market price of risk for efficient portfolios. It is also called the equilibrium market price of risk.4 It indicates the additional return that the market demands for each percentage increase in a portfolio’s risk, that is, in its standard deviation of return.

Example:

Assume that the expected return on portfolio M is 13 percent, with a standard deviation of 20 percent, and that RF is 5 percent. The slope of the CML is 

( 0.13 - 0.05 ) / 0.20 = 0.40 

In our example a risk premium of 0.40 indicates that the market demands this amount of return for each percentage increase in a portfolio’s risk.




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