Capital Market Line (CML)

The Capital Market Line (CML) is a graphical representation of the relationship between risk and return for all possible portfolios of risky assets. It is a straight line that connects the risk-free rate of return with the market portfolio, which is the portfolio of all risky assets in the economy. The CML is a useful tool for investors because it allows them to compare the risk and return of different portfolios and to make informed investment decisions.

The CML is constructed by plotting the expected return of each portfolio on the vertical axis and the standard deviation of each portfolio on the horizontal axis. The risk-free rate of return is plotted as a point on the horizontal axis, and the market portfolio is plotted as a point on the CML. The slope of the CML is equal to the market risk premium, which is the difference between the expected return of the market portfolio and the risk-free rate of return.

The CML can be used to make several important investment decisions. First, it can be used to determine the risk-return trade-off of different portfolios. For example, a portfolio with a higher standard deviation will have a higher expected return than a portfolio with a lower standard deviation. Second, the CML can be used to determine the optimal portfolio for an investor with a given level of risk tolerance. An investor with a high risk tolerance will be willing to invest in a portfolio with a higher standard deviation and a higher expected return. An investor with a low risk tolerance will be willing to invest in a portfolio with a lower standard deviation and a lower expected return.

The CML is a valuable tool for investors because it provides a visual representation of the relationship between risk and return. It can be used to make informed investment decisions and to achieve the desired risk-return trade-off.

In addition to the risk-free rate of return and the market portfolio, the CML also includes the security market line (SML). The SML is a line that represents the relationship between risk and return for individual stocks. The SML is constructed by plotting the expected return of each stock on the vertical axis and the beta of each stock on the horizontal axis. The beta of a stock is a measure of its volatility relative to the market. The slope of the SML is equal to the market risk premium.

The CML and the SML are important tools for understanding the relationship between risk and return. They can be used to make informed investment decisions and to achieve the desired risk-return trade-off.