Capital Allocation Line - CAL

What is the 'Capital Allocation Line - CAL'

The capital allocation line (CAL), also known as the capital market link (CML), is a line created on a graph of all possible combinations of risk-free and risky assets. The graph displays to investors the return they might possibly earn by assuming a certain level of risk with their investment. The slope of the CAL is known as the reward-to-variability ratio.

BREAKING DOWN 'Capital Allocation Line - CAL'

The CAL aids investors in choosing how much to invest in a risk-free asset and one or more risky assets. Asset allocation is the allotment of funds across different types of assets with varying expected risk and return levels, whereas capital allocation is the allotment of funds between risk-free assets, such as certain Treasury securities, and risky assets, such as equities.

Constructing Portfolios With the CAL

An easy way to adjust the risk level of a portfolio is to adjust the amount invested in the risk-free asset. The entire set of investment opportunities includes every single combination of risk-free and risky assets. These combinations are plotted on a graph where the y-axis is expected return and the x-axis is the risk of the asset as measured by standard deviation.

The simplest example is a portfolio containing two assets: a risk-free Treasury bill and a stock. Assume that the expected return of the Treasury bill is 3% and its risk is 0%. Further, assume that the expected return of the stock is 10% and its standard deviation is 20%. The question that needs to be answered for any individual investor is how much to invest in each of these assets. The expected return (ER) of this portfolio is calculated as follows:

ER of portfolio = ER of risk-free asset x weight of risk-free asset + ER of risky asset x (1- weight of risk-free asset)

The calculation of risk for this portfolio is simple because the standard deviation of the Treasury bill is 0%. Thus, risk is calculated as:

Risk of portfolio = weight of risky asset x standard deviation of risky asset

In this example, if an investor were to invest 100% into the risk-free asset, the expected return would be 3% and the risk of the portfolio would be 0%. Likewise, investing 100% into the stock would give an investor an expected return of 10% and a portfolio risk of 20%. If the investor allocated 25% to the risk-free asset and 75% to the risky asset, the portfolio expected return and risk calculations would be:

ER of portfolio = (3% x 25%) + (10% * 75%) = 0.75% + 7.5% = 8.25%

Risk of portfolio = 75% * 20% = 15%

Slope of the CAL

The slope of the CAL measures the trade-off between risk and return. A higher slope means that investors receive higher expected return in exchange for taking on more risk. The value of this calculation is known as the Sharpe ratio.

RELATED TERMS
  1. Risk-Free Return

    The theoretical rate of return attributed to an investment with ...
  2. Risk-Free Asset

    An asset which has a certain future return. Treasuries (especially ...
  3. Risk-Free Rate Of Return

    The theoretical rate of return of an investment with zero risk. ...
  4. Risk Premium

    The return in excess of the risk-free rate of return that an ...
  5. Capital Market Line - CML

    A line used in the capital asset pricing model to illustrate ...
  6. Market Risk Premium

    The difference between the expected return on a market portfolio ...
Related Articles
  1. Markets

    Risk-Free Rate of Return

    The risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free ...
  2. Managing Wealth

    Understanding Market Risk Premium

    Market risk premium is equal to the expected return on an investment minus the risk-free rate. The risk-free rate is the minimum rate investors could expect to receive on an investment if it ...
  3. Markets

    How Risk Free Is The Risk-Free Rate Of Return?

    This rate is rarely questioned - unless the economy falls into disarray.
  4. Managing Wealth

    Understanding The Sharpe Ratio

    This simple ratio will tell you how much that extra return is really worth.
  5. Markets

    Explaining the Capital Market Line

    The capital market line (CML) depicts the level of additional return above the risk-free rate for each change in the level of risk.
  6. Financial Advisor

    Risk-Free & 20% Return? More Like 100% Scam

    An investment that promises a risk-free return of 20% is 100% likely to be a scam.
  7. Managing Wealth

    Measure Your Portfolio's Performance

    Learn three ratios that will help you evaluate your investment returns.
  8. Managing Wealth

    Choose Your Own Asset Allocation Adventure

    There are many strategies to help balance your portfolio. Here are a few to get you started.
  9. Trading

    Modern Portfolio Theory: Why It's Still Hip

    See why investors today still follow this old set of principles that reduce risk and increase returns through diversification.
  10. Managing Wealth

    More Ways to Evaluate Portfolio Performance

    The Jensen measure is another tool investors use to include risk when measuring portfolio performance.
RELATED FAQS
  1. How is it possible for a rate to be entirely risk-free?

    Find out whether there really is such a thing as a risk-free rate of return, and learn why taking the idea of risk-free rates ... Read Answer >>
  2. What is the correlation between equity risk premium and risk?

    Learn about the relationship between the risk-free rate of return and the equity risk premium, and understand how the risk-free ... Read Answer >>
  3. How accurate is the equity risk premium in evaluating a stock?

    Learn about the drawbacks of using the equity risk premium to evaluate a stock, and understand how it is calculated using ... Read Answer >>
  4. How is the risk-free rate of interest used to calculate other types of interest rates ...

    Learn how the risk-free rate is used to compare the yields on bonds, and understand how T-bills are used as a proxy for the ... Read Answer >>
  5. How is the risk-free rate determined when calculating market risk premium?

    Learn how the risk-free rate is used in the calculation of the market risk premium, and understand why T-bills provide the ... Read Answer >>
  6. What is the breakdown of subjects covered on the Series 6 exam?

    Learn about the risk-return tradeoff for investing in stocks versus low-risk Treasurys and bonds, and understand the types ... Read Answer >>
Hot Definitions
  1. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  2. GBP

    The abbreviation for the British pound sterling, the official currency of the United Kingdom, the British Overseas Territories ...
  3. Diversification

    A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique ...
  4. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  5. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  6. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
Trading Center