What is Capital Market Line?
Capital Market Line was developed by William Sharpe and John Lintner in the 1960s. It is a graphical representation of all portfolios that combine risk and return in the best possible way. CML is a theoretical idea that determines the best risk-free asset and market portfolio pairings. It builds on the concepts of Market Portfolio Theory, and the CML in the investors are assumed to hold some combination of the risk-free asset and the market portfolio.
Example of Capital Market Line:
Re=RF+(RM-RF)/σ x Mσe
RF=risk free rate
σMM=standard deviation of market returns
σe=standard deviation of portfolio returns
Suppose the current risk-free rate is 5%, and the expected market return is 18%. The standard deviation of the market portfolio is 10%.
Now let’s take two portfolios with different Standard Deviations:
Portfolio = 5%
Using the Capital Market Line Formula:
= 5% +5%* (18%-5%)/10%
Why is the capital market line (CML) important?
Theoretically, portfolios that fall on the capital market line (CML) maximise the risk/return relationship, resulting in maximum performance. As a result, the Sharpe ratio of the market portfolio equals the slope of the CML. CML forms the basics of any investment risk management decisions and should be known well by risk professionals.