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What is the 'Capital Market Line - CML'

The capital market line (CML) appears in the capital asset pricing model to depict the rates of return for efficient portfolios subject to the risk level (standard deviation) for a market portfolio and the risk-free rate of return.

The capital market line is created by sketching a tangent line from the intercept point on the efficient frontier to the place where the expected return on a holding equals the risk-free rate of return. However, the CML is better than the efficient frontier because it considers the infusion of a risk-free asset in the market portfolio.

BREAKING DOWN 'Capital Market Line - CML'

The capital asset pricing model (CAPM) proves that the market portfolio is the efficient frontier. It is the intersection between returns from risk-free investments and returns from the total market. The security market line (SML) represents this.

The capital asset pricing model determines the fair price of investments. Once the fair value is determined, it is compared to the market price. A stock is a good buy if the estimated price is higher than the market price. However, if the price is lower than the market price, the stock is not a good buy.

In the CAPM, the securities are priced, so the expected risks counterbalance the expected returns. There are two components needed to generate a CAPM, CML and the SML. The capital market line conveys the return of an investor for a portfolio. The capital market line assumes that all investors can own market portfolios.

Single assets and nonefficient portfolios are not depicted on the CML. Alternatively, the SML must be used. The capital market line permits the investor to consider the risks of an additional asset in an existing portfolio. The line graphically depicts the risk top investors earn for accepting added risk.

Separation Theorem

All investors have portfolios on the CML relying on the risk-return preferences. However, the market portfolio and the CML are depicted without reference to the risk-return tradeoff curves of the investors. This result is Tobin’s Separation Theorem. It states that the best blend of risky assets in the market portfolio is determined without considering the risk-return preferences of the investors.

Locating the best portfolio for a specific risk tolerance level consists of two methods: finding the best blend of market securities that does not fluctuate with risk tolerance and then joining it with a suitable amount of money.

History

In 1952, Harry Markowitz wrote his doctoral dissertation titled Portfolio Selection that recognized the efficient frontier. In 1958, James Tobin included leverage to the portfolio theory by including in the analysis an asset that pays a risk-free rate. However, when combining a no-risk asset with a portfolio on the efficient frontier, it is possible to assemble portfolios whose risk-return profiles are above those of portfolios on the efficient frontier.

In 1964, William Sharpe developed the CAPM that exhibits assumptions; the efficient portfolio has to be the market portfolio. Based on this, typical investors must keep the market portfolio leveraged or deleveraged to realize their desired risk.

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