CAPITAL MARKET LINE

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.

GRAPH
Capital market line (CML) is a graph that reflects the expected return
of a portfolio consisting of all possible proportions between the
market portfolio and a risk-free asset.
• Line from RF to L is capital market line
• x= risk premium = E(RM) – RF
• Y = risk = σM
• Slope = x/y = market price of risk for efficient portfolios = (E(RM)
– RF)/ σM
 CML EQUATION

where,
Expected Return of Portfolio
Risk-Free Rate
Standard Deviation of Portfolio
Expected Return of the Market
Standard Deviation of Market

ILLUSTRATION

Suppose that the current risk-free rate is 5% and the expected

market return is 20%. The standard deviation of the market portfolio
is 10%.
Suppose there are two portfolios:
Portfolio A = 5%
Portfolio B = 15%
What is the expected return of two portfolios?
SOLUTION
Expected rate of return of portfolio A= 5% +5%* (20%-5%)/10%
ER(A) = 12.5%
Expected rate of return of portfolio B= 5% +15% (20%-5%)/10%
ER(B) = 27.5%
 REFERENCE
https://www.wallstreetmojo.com/capital-market-line/
https://xplaind.com/282223/capital-market-line
https://en.wikipedia.org/wiki/Capital_market_line