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What is meant by Capital Market Line?
Capital Market Line (CML) is a line that talks about a portfolio that accurately combines both risk and returns. It is a graphical representation that shows a portfolio’s expected and required return based on a chosen level of risk. The portfolios that are on the CML optimize the required risk and return relationship that maximizes the performance of the portfolio.
Note − The slope of Capital Market Line is known as the Sharpe Ratio of the market portfolio. It is now believed by many investors that one should buy a security if the Sharpe ratio is above the CML and sell if it is below.
The "efficient frontier" is more popular for investment measurement than CML, but they are completely different because the efficient frontier has all risk-free investments. The interception point of the CML and efficient frontier is known as the tangency portfolio. The tangency portfolio gives the most efficient portfolio.
Investors often tend to believe that CML and Security Market Line (SML) are the same. The security line is different from CML and is derived from the CML itself. CML represents portfolio ROI, whereas SML represents the market risk as well as the given period’s return.
More about Capital Market Line
The CML graphically shows all the portfolios with a maximum mix of risk and return. These are the best portfolios with greater returns. The graph of CML risk is represented by using standard deviation (SD) on the Xaxis, while the expected return of a portfolio is placed on the Yaxis. The line consists of risky and risk-free assets. Thereby, it offers an optimal risk-return trade-off i.e. maximum actual return on a given amount of risk or minimum risk on a chosen return.
The CML assumes the risk portfolio as the market portfolio. Graphically, a line that connects the market portfolio with the risk-free asset represents the line. This is the capital market line. In the case of the graph, the return and risks are proportional to each other. That is when risk goes up, the returns also climb up in the CML.
According to the Separation Theorem, deriving the market portfolio and finding the best combination of that market portfolio and the risk-free assets are different problems. Individual investors may hold just the risk-free asset or a combination of the market portfolio and the risk-free asset depending on the amount of risk they want to take. While moving up the CML, portfolio risk and reward from the investment increase.
Risk-averse investors will often select the assets that are risk-free or those near the risk-free line-up, preferring low variance and greater returns. Investors looking for higher returns will prefer portfolios higher up on the CML line, with a higher expected return, but with more variance. When the investors borrow funds at a risk-free rate, they become able to invest more than 100% of their available funds in the risky market portfolio which will increase both the expected return and the risk.
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