Capital Market Line (CML)
Candlefocus EditorThe CML is a linear plot that consists of two major components. The first is the efficient frontier, which is the collection of portfolios consisting of numerous combinations of the risk-free asset and the market portfolio that show the highest return for a given level of risk. All possible combinations of these two assets are located on the efficient frontier, except for when their returns are equal.
The second component of the CML is the risk-free asset, which is represented by the vertical axis. This is the risk-free rate of return that any investor can obtain by investing in a risk-free asset such as U.S. Treasury bonds.
The slope of the CML is determined by the Sharpe ratio, which is the measure of risk-adjusted return relative to the return of the market portfolio. The higher the Sharpe ratio, the steeper the slope of the CML.
The CML provides a useful tool for investors seeking to construct portfolios with the best possible risks and returns. By combining investments in the risk-free asset and market portfolio, investors can find an optimal combination of the two that will allow them to achieve maximum returns for a given level of risk.
The CML also helps investors to identify which securities are undervalued or overvalued in relation to the market portfolio. When the Sharpe ratio of a security is lower than that of the CML, this means that it is undervalued, and when it is higher, it is overvalued. Therefore, investors can use the CML as a means of looking for inefficiencies in the market.
Finally, the tangency portfolio is the most efficient portfolio that can be constructed using the CML. It is a combination of the market portfolio and risk-free asset that will result in the maximum expected return for a given level of risk. This is the optimal portfolio that any investor should aim to build.
In conclusion, the capital market line is an effective analytical tool that can be used to construct optimal portfolios with the best possible balance of risk and return. Investors should use the CML and its components as a guide for constructing portfolios that maximize returns and minimize risk.