Capital market line is a kind of graph. This graph has originated from the Capital Asset Pricing Model. The Capital Market Line is used for determining the rates of return for certain efficient portfolios. These analysis are depending on the risk free rate of return and the amount of risk involved in particular portfolio.
The experts always prefer CML than the efficient frontier because the capital market line considers the addition of a risk free asset in the portfolio. According to the Capital Asset Pricing Model, the market portfolio represents the efficient frontier.
To understand the capital market line properly, one should have proper knowledge about the market portfolio. Efficient frontier can be defined as an ingathering of portfolios. Every portfolio included in the market portfolio optimum for a certain amount of risk. There is an another term which is known as Sharpe ratio.
The Sharp ratio, through certain calculations, represent the proportion of risk and extra return, a portfolio provides. Now, the portfolio which has the highest Sharp ratio is known as the market portfolio. The market portfolio when combined with the risk free asset, is capable of producing a high return than the efficient frontier. The combination of the market portfolio and the risk free asset gives birth to the Capital Market line.
Another very important term which is related with the Capital Market Line is the Capital Asset Pricing Model. This model is used to confirm a theoretically suited necessary rate of return of an asset at a time, when it is about to be added to an existing and good going portfolio. The amount of risk related to the particular asset is considered with importance.