Capital Market Line (CML)

The capital market line (CML) is a kind of graph, originating from the capital asset pricing model (CAPM). The CAPM is used to confirm a theoretically-suited necessary rate of return on an asset when it is about to be added to an existing and well-performing portfolio.
The CML is used to determine the rate of return for certain efficient portfolios. This analysis is dependent upon the risk-free rate of return and the amount of risk involved in a particular portfolio. The Sharpe ratio, through certain calculations, represents the proportion of risk and extra return that a portfolio provides.

The portfolio which has the highest Sharpe ratio is known as the market portfolio. Every portfolio included in the market portfolio is optimized for a certain amount of risk. The amount of risk related to the particular asset is considered with importance.

Capital Market Line Formula:

{\mathrm {CML}}:E(r)=r_{f}+\sigma {\frac {E(r_{M})-r_{f}}{\sigma _{M}}}.

 

Capital market line, Sharpe ratio and alpha

{\frac {E(r)-r_{f}}{\sigma }}={\frac {E(r_{M})-r_{f}}{\sigma _{M}}}.

According to the CAPM, the market portfolio represents the efficient frontier. The efficient frontier can be defined as an ingathering of portfolios. The market portfolio, when combined with the risk-free asset, is capable of producing a higher return than the efficient frontier.
The combination of the market portfolio and the risk-free asset gives birth to the CML. Experts tend to prefer CML over the efficient frontier because the CML considers the addition of a risk-free asset in the portfolio.

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Last Updated on : 21st July 2016