CML Theory

Capital Market Line Theory

James Tobin (1958) added the notion of
leverage to portfolio theory by
incorporating into the analysis an
asset which 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
riskreturn profiles are superior to
those of portfolios on the efficient
frontier. Consider Exhibit 1 next page

Capital Market Line

CML
In the Picture ,
the risk-free rate is assumed to be 2%, and a tangent linecalled the
capital market linehas 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:
Leverage their position by shorting the risk-free asset and investing
the proceeds in additional holdings in the super-efficient portfolio, or
De-leverage their position by selling some of their holdings in the
super-efficient portfolio and investing the proceeds in the risk-free
asset.

CML
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 twostep process. First, investors should determine the superefficient 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 investors appetite for risk.

The two decisions:

The composition of the risky portion of the investors
portfolio, and the amount of leverage to use, are entirely
independent of one another. One decision has no effect on
the other. This is called Tobins separation theorem.
William Sharpes (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.

CML Formula
CML Formula

CML explanation
The capital market equation tells as the
expected return of a two asset portfolio,
consisting of one risk free asset and one
risky asset.
Risk free assets are usually government
securities, such as Australian or USA
treasury bills as they pay a fixed rate of
return and have a low default rate. One
wouldnt ever expect the Australian and
US government to go bust.

Risk and Return

The Capital Market Line graphed

The graph depicts the following:
The CML assumes that there are only two assets, a risk
free asset and a risky asset. The vertical axis measures
the expected return of an asset. The horizontal axis
measures the risk of an asset.
Expected return and risk are positively correlated.
That is, when expected return of a portfolio increases, so
does the risk. Thus the CML is has a positive gradient.
The gradient of the CML is P represents a risky asset. As
you can see, the higher the expected return, the higher
the risk.

CML

CML Explained
The risk free asset cuts the vertical axis. As the graph shows the
risk free asset has an expected level of return for 0 risk. That is, the
standard deviation f. of a risk free asset is 0,
Rational investors will choose a point on the CML between the risk
free (rf) asset and the risky asset (M), such as point P.
The closer the investor chooses an asset towards the risk free asset
(rf), the more risk adverse the investor is and thus the less risk the
investor is willing to take.
You can choose to invest 100% of their funds in risky assets (M) and
0% of their funds in risk free assets. You can even invest to the right
of M into even risky assets by borrowing at the risk free rate.

CML Explanation
The whole idea of the CML is that
rational investors will choose a point
on the CML between the risk free
asset and the risky asset, like point P.
Investors will be rewarded the
expected return of the risk free rate
plus a risk premium for investing into
the risky asset.
The risk premium is

CML explained
Lets look at it this way. Say you have $1,000 to
invest. By investing the entire $1,000 into the
risk free asset you can earn 5% and incur no
risk.
In the end you will have $1,050 ($1,000 x 1.05).
If you invest your $1,000 entirely into the risky
asset (M) then your expected return is 15%.
This is your market risk premium in an
additional 10 %
above the
risk free rate for taking on the additional risk.

CML explanation
Rational investors will invest somewhere between the risk free asset
and the risky asset (M). A balanced portfolio for a risk adverse
investor may be to invest 40% of funds into the risk free asset and
60% into the risk asset.
So if you were investing $1,000, you would invest $400 into the
risk free asset and $600 into the risky asset, which would lie to the
right of point P of the graph above.
Say an investor decides to invest $400 into a risk free asset and $600
into a risky asset. What is the overall risk of the portfolio? The overall
risk of the portfolio is simply the risk (or standard deviation m of
the
risky asset multiplied by the percentage of funds allocated to that
risky
asset.

CML explained

 The CML then extends linearly to a point where the CML is

tangent to the efficient frontier. This point is referred to as
the market portfolio.
The market portfolio includes all risky assets (and only risky
assets). The market portfolio contains only systematic risk;
all non-systematic risk has been diversified away.
The risky assets are included in proportion to their market
value, however only risky assets with a positive market
value are included (i.e., those assets for which there is a
demand). There are no risk-free assets in the market
portfolio.

 Every investor (presumably) wants to invest in the

market portfolio and either lend money at the riskfree rate (i.e., purchase T-bills) or borrow money at
the risk-free rate (i.e., use leverage) to purchase
additional risky-assets.
If the blended portfolio lies on the CML somewhere
between the Rf intercept (i.e., the risk-free rate)
and point of tangency (i.e., the market portfolio),
the investors portfolio consists of a blend of T-bills
and some proportion of risky assets

 If the investors portfolio lies on the CML

beginning at the market portfolio or beyond, the
investors portfolio consists only risky at assets.
Leverage is not utilized at the point of tangency
(i.e., the market portfolio).
But as the investor moves beyond the market
portfolio on the CML, leverage is utilized. An
investors risk preference will determine the
investors portfolio position on the CML.

 There is a direct correspondence

between the proportion of risk-free
assets and risky assets in the investors
portfolio and the portfolios risk ().
For example, if an investors portfolio
consists of 50% risk-free assets and
50% risky assets, the investors
portfolio risk is 50% of the market
portfolios standard deviation ()

 There is a direct correspondence between the

proportion of risk-free assets and risky assets
in the investors portfolio and the portfolios
risk (). For example, if an investors portfolio
consists of 50% risk-free assets and 50% risky
assets, the investors portfolio risk is 50% of
the market portfolios standard deviation ();
if the investors portfolio consists of 20% riskfree assets and 80% risky assets, the
investors portfolio risk is 80% of the market
portfolios standard deviation (), etc

This states that the return of a diversified portfolio on the CML is

equal to the risk free rate plus a risk premium. The clear conclusion
of the CML equation is higher returns require additional risk. If the
standard deviation of the market and the portfolio are the same
they cancel each other out and the return of the portfolio is simply
the risk free rate plus the market risk premium (rm - rf).
If the standard deviation of the market is greater than the
portfolios standard deviation then the risk premium will be smaller
reducing the return of the portfolio;
if the standard deviation of the market is less than the portfolios
standard deviation then the risk premium will be larger increasing
the return of the portfolio.
The CMLs slope indicates the additional incremental return
expected by the marketplace (due to the increased risk premium)
for each incremental increase in risk.

The CML does not specify the risk/reward

relationship for individual securities or inefficient
portfolios (that is specified by the security
market the SML line discussed on page INV
80). Only efficient portfolios are on the CML (i.e.,
portfolios that do not posses any diversifiable
risk). Inefficient portfolios (e.g., a large cap
growth fund, a sector fund, a global fund, etc.)
or individual securities will not plot on the CML
the SML must be used instead.

CML Equation

 The slope of the CML identifies the market price of risk

which is calculated by the portion of the CML formula within
the parentheses:

For example, if the rm is 10%, the rf is 3%, and the m is

20%, the slope of the CML is 0.07 0.20 = 0.35%.
What does a slope of 0.35% mean?
For every 1% increase in risk the expected/required return
increases by 0.0035 or 0.35%.
In other words, the market is saying that an additional
0.35% return will cost an additional 1% in risk, or an
additional 1% return will cost approximately 2.86% in risk.

Example
Assume that two securities constitute the market portfolio. Those securities
have the following expected returns, standard deviations, and proportions:
Security A
Expected return 10%
Standard Deviation 20%
Proportion .4
Security B
Expected return 15%
Standard Deviation 28%
Proportion .6
Based on this information, and given a correlation of .30 between the two
securities and a risk-free rate of 5%, specify the equation for the capital
market line.

The capital market line (CML) will have the form:

E(r_c) = r(f) + stdev(c) * [ E(r_m) - r(f) ] / stdev(m)
where:
E(r_c) = the expected return on portfolio c
r(f) = the risk-free rate
stdev(c) = the standard deviation of portfolio c
E(r_m) = the expected return on the market portfolio m
stdev(m) = the standard deviation of the market portfolio
m

 From here, we just have to solve or plug in the values for the following
variables:
r(f), E(r_m), and stdev(m)
r(f) = 0.05 = 5.0%
(this was given in the information above);
E(r_m) = (0.1*0.4) + (0.15*0.6) = 0.13 = 13.0%
(calculated as a weighted average of the securities' expected returns by
their proportions in the market portfolio)
stdev(m) = ((0.4^2)*(0.2^2) + (0.6^2)*(0.28^2) +
(2*0.4*0.6*0.2*0.28*0.3))^0.5 = 0.2066 = 20.66%
(calculated by taking the square root of portfolio m's variance; portfolio m's
variance is calculated as a weighted average of the securities' covariances)

Now that the relevant variables have been calculated, you can
just plug them in:
E(r_c) = 5.0% + stdev(c) * [ 13.0% - 5.0% ] / 20.66%
Therefore, the CML you're looking for is:
E(r_c) = 5.0% + stdev(c) * 0.3872
As in investor, you simply choose how much risk (i.e. stdev(c) )
you're willing to accept, and you can use the CML equation to
calculate your expected return for that level of accepted risk.
Another way to think about it is if an investor has a
predetermined level of expected returns he/she wants to obtain,
the CML will tell her/him how much risk (i.e. stdev(c)) will be
involved.

Difference CML and SML

CML stands for Capital Market Line, and
SML stands for Security Market Line.
The CML is a line that is used to show
the rates of return, which depends on
risk-free rates of return and levels of
risk for a specific portfolio. SML, which is
also called a Characteristic Line, is a
graphical representation of the markets
risk and return at a given time.

 One of the differences between CML and SML, is

how the risk factors are measured. While standard
deviation is the measure of risk for CML, Beta
coefficient determines the risk factors of the SML.
The CML measures the risk through standard
deviation, or through a total risk factor. On the other
hand, the SML measures the risk through beta,
which helps to find the securitys risk contribution
for the portfolio.
While the Capital Market Line graphs define
efficient portfolios, the Security Market Line graphs
define both efficient and non-efficient portfolios.

 While calculating the returns, the expected

return of the portfolio for CML is shown along
the Y- axis. On the contrary, for SML, the
return of the securities is shown along the Yaxis. The standard deviation of the portfolio is
shown along the X-axis for CML, whereas, the
Beta of security is shown along the X-axis for
SML.
Where the market portfolio and risk free
assets are determined by the CML, all security
factors are determined by the SML.

 Unlike the Capital Market Line, the

Security Market Line shows the
expected returns of individual assets.
The CML determines the risk or
return for efficient portfolios, and the
SML demonstrates the risk or return
for individual stocks.
Well, the Capital Market Line is
considered to be superior when
measuring the risk factors.

Summary:
1. The CML is a line that is used to show the rates of return, which
depends on risk-free rates of return and levels of risk for a
specific portfolio. SML, which is also called a Characteristic Line,
is a graphical representation of the markets risk and return at a
given time.
2. While standard deviation is the measure of risk in CML, Beta
coefficient determines the risk factors of the SML.
3. While the Capital Market Line graphs define efficient portfolios,
the Security Market Line graphs define both efficient and nonefficient portfolios.
4. The Capital Market Line is considered to be superior when
measuring the risk factors.
5. Where the market portfolio and risk free assets are determined
by the CML, all security factors are determined by the SML.