Business, Legal & Accounting Glossary
A capital market line (CML) is a line intersecting returns on no-risk investments and returns on the entire market. The difference between the capital market line and the efficient frontier is that the capital market line includes no-risk investments. All portfolios along the capital market line are efficient portfolios.
The capital market line is used to evaluate portfolio performance. Any point below any other point on the line will deliver lower returns but the same risk and is therefore not ideal.
The capital market line is referred to as a measure employed to evaluate portfolio performance. A capital market line or CML is a graph employed in asset pricing models to depict rates of return in a market portfolio. The capital market line describes rates of return for efficient portfolios that are dependent on the level of risk and the risk-free rate of return for a specific portfolio. CML originates from the assumption that all investors will possess a market portfolio. Quantum of risk is positively correlated to the expected return. Thus, the equation representing an expected return is as follows:
Expected return= portfolio beta + risk-free rate
The capital market line is deduced by drawing a tangent line that starts from the intercept point located on the efficient frontier and extends to the point where the expected return matches the risk-free rate of return. The capital market line is believed to be a better measure than the efficient frontier as it takes into consideration risk-free assets in a portfolio. All points on the CML have better risk-return profiles when compared to any portfolio located on the efficient frontier.
The capital asset pricing model (CAPM) is an economic model that is used for valuing stocks on relating expected return and risk. It is founded on the presumption that investors call for supplemental return if compelled to bear the extra risk.
The characteristic line is a line defined by utilizing regression analysis that sums up a specific security’s or portfolios systematic risk and rate of return. The rate of return is subject to the characteristic line’s slope and standard deviation of returns of the specific asset. The slope of the characteristic line is typified by the asset’s beta. The slope ascertains the risk-return trade-off. A greater risk is matched by greater returns.
Modern portfolio theory (MPT) also known as ‘portfolio theory’ or ‘portfolio management theory’ is an investment strategy that wishes to build an optimized portfolio that takes into account the relationship between risk and return. MPT stresses that risk is implicit in better rewards.
James Tobin (1958) added the notion of leverage to portfolio theory by incorporating into the analysis an asset that pays a risk-free rate. By combining a risk-free asset with a portfolio on the efficient frontier, it is possible to construct portfolios whose risk-return profiles are superior to those of portfolios on the efficient frontier. Consider Exhibit 1:
In Exhibit 1, the risk-free rate is assumed to be 2%, and a tangent line—called the capital market line—has been drawn to the efficient frontier passing through the risk-free rate. The point of tangency corresponds to a portfolio on the efficient frontier. That portfolio is called the super-efficient portfolio.
Using the risk-free asset, investors who hold the super-efficient portfolio may:
The resulting portfolios have risk-reward profiles which all fall on the capital market line. Accordingly, portfolios which combine the risk-free asset with the super-efficient portfolio are superior from a risk-reward standpoint to the portfolios on the efficient frontier.
Tobin concluded that portfolio construction should be a two-step process. First, investors should determine the super-efficient portfolio. This should comprise the risky portion of their portfolio. Next, they should leverage or de-leverage the super-efficient portfolio to achieve whatever level of risk they desire. Significantly, the composition of the super-efficient portfolio is independent of the investor’s appetite for risk. The two decisions:
are entirely independent of one another. One decision has no effect on the other. This is called Tobin’s separation theorem.
William Sharpe’s (1964) capital asset pricing model (CAPM) demonstrates that, given strong simplifying assumptions, the super-efficient portfolio must be the market portfolio. From this standpoint, all investors should hold the market portfolio leveraged or de-leveraged to achieve whatever level of risk they desire.
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This glossary post was last updated: 29th December, 2021 | 61 Views.