What is Capital Market Line ?

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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.

Definition

The Capital Market Line (CML) represents the optimal portfolio of risk and return. It is a theoretical concept that represents all portfolios optimally combining 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, balancing by borrowing at the risk-free rate to maximize returns for a given level of risk.

Origin

The concept of the Capital Market Line originates from the Capital Asset Pricing Model (CAPM), developed by William Sharpe in the 1960s. The introduction of CAPM marked a significant milestone in modern financial theory, providing a framework for understanding the relationship between risk and return.

Categories and Features

The main feature of the Capital Market Line is that it shows the optimal risk-return combination between risk-free assets and the market portfolio. The slope of the CML represents the market risk premium, which is the difference between the expected return of the market portfolio and the risk-free rate. Investors can adjust the risk level of their portfolio by choosing different points on the CML.

Case Studies

A typical case is Investor A choosing to invest in a portfolio on the CML that includes 50% risk-free assets and 50% market portfolio to achieve moderate risk and return. Another case is Investor B borrowing funds at the risk-free rate to invest in the market portfolio, thus choosing a higher risk and return point on the CML.

Common Issues

Investors may encounter issues when applying the CML, such as accurately estimating the expected return and risk of the market portfolio and achieving the theoretically optimal combination under real market conditions. Additionally, changes in market conditions can alter the slope and position of the CML.

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