Capital Market Line
The capital market line (CML) represents portfolios that optimally combine risk and return. 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 the capital asset pricing model (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)
Definition
The Capital Market Line (CML) represents the optimal combination of risk and return for an investment portfolio. It is a theoretical concept that represents all portfolios that optimally combine the risk-free rate and the market portfolio of risky assets. Under the Capital Asset Pricing Model (CAPM), all investors will choose a position on the CML by borrowing or lending at the risk-free rate to achieve balance, as this maximizes returns for a given level of risk.
Origin
The concept of the Capital Market Line originates from the Capital Asset Pricing Model (CAPM), which was introduced by William Sharpe and John Lintner in the 1960s. CAPM explains how to achieve an optimal portfolio at different levels of risk by introducing the risk-free asset and the market portfolio.
Categories and Characteristics
The Capital Market Line has the following key characteristics:
- Risk-Free Rate: The starting point of the CML is the risk-free rate, typically represented by the yield on government bonds.
- Market Portfolio: The slope of the CML is determined by the market portfolio's risk premium, which includes all investable risky assets.
- Linear Relationship: The CML represents a linear relationship between the expected return of a portfolio and its risk at different levels of risk.
Specific Cases
Case 1: Suppose an investor has $100,000 and can choose to invest part of it in risk-free assets (such as government bonds) and the rest in the market portfolio (such as a stock market index). If the risk-free rate is 2%, the expected return of the market portfolio is 8%, and the standard deviation of the market portfolio is 15%, the investor can achieve different combinations of risk and return by adjusting the proportion of risk-free assets and the market portfolio.
Case 2: Another investor wants to increase the risk and return of their portfolio by borrowing. If they borrow $50,000 at the risk-free rate and invest a total of $150,000 entirely in the market portfolio, their portfolio's expected return will increase, but so will the risk.
Common Questions
Question 1: Why is the Capital Market Line a straight line?
Answer: Because under the CAPM model, there is a linear relationship between the expected return of a portfolio and its risk.
Question 2: How to choose the best position on the Capital Market Line?
Answer: Investors should choose the appropriate proportion of risk-free assets and the market portfolio based on their risk tolerance and expected return goals.
