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:
Capital market line, Sharpe ratio and alpha
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.
Last Updated on : 21st July 2016