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What is Capital Market Line (CML)?

Capital Market Line:
It shows the relationship between risk (standard deviation) and return of risk free asset and market portfolio (All the financial investment available in proportion of they are available in a market). The slope of the Capital Market Line shows the price of market risk. The efficient portfolio is a reward for waiting and bearing a risk of holding that portfolio for specified period.



In the above diagram standard deviation is shown in X axis and expected return and risk free asset. The curve shown in the diagram is known as efficient frontier curve.  If the investors prefer less risk then they must lying between risk free asset points to market portfolio point. Between these two points investor can lend money to government by buying treasury bills, government bonds on risk. If the investors are interested in taking more risk to earn high return, then those investors lying beyond the market portfolio point. And beyond the market portfolio point the investor can borrow funds on risk free rate for buying risky assets.

Difference between Capital Market Line and Security Market Line:
·         The CML shows the total risk as standard deviation while the SML shows market risk as beta.
·         The efficient frontier curve shown in CML only while inefficient portfolio shown in SML.
·         The capital market line shows risk and return relationship as a whole market while the relationship of risk and return of single stock is shown by security market line.

Formula:
E(Rp) = Rf + σp ((Rm – Rf) / σm)

Where,
E(Rp) = Expected return of a portfolio
Rf = Risk free rate of return
σp = Standard deviation of a portfolio
σm = Standard deviation of market
Rm = Market rate of return
Example: Find out the expected return of a portfolio if the market standard deviation is 23% and risk free rate is 4%. The market return is 12% and the standard deviation of portfolio is 5%.
Solution:
E(Rp) = Rf + σp ((Rm – Rf) / σm)
= 4 + 5 ((12 – 4) / 23
= 4 + 5*0.35
= 4 + 1.75
= 5.75%



Example: Find out the expected return of given portfolio with the help of given information:

Portfolio
Standard deviation of portfolio (in %)
Risk free rate in %)
Expected market return
Standard deviation of market portfolio
A
2
3
13
5
B
8
3
18
4
C
4
3
9
8
D
6
3
11
2

 Solution:
E (Rp) = Rf + σp ((Rm – Rf) / σm)
Portfolio A:
= 3 + 2 ((13 – 3) / 5)
= 3 + 2*2
= 3 + 4
= 7%
Portfolio B:
= 3 + 8 ((18 -3) /4)
= 3 + 8*3.75
= 3 + 30
= 33%
Portfolio C:
= 3 + 4((9 – 3) / 8)
= 3 + 4*0.75
= 3 + 3
= 6%
Portfolio D:
= 3 + 6((11 -3) / 2)
= 3 + 6*4
= 3 + 24
= 27%


Example: Find out which portfolio gives higher return from the given information:

Portfolio
Standard deviation of portfolio (in %)
Risk free rate in %)
Expected market return
Standard deviation of market portfolio
P
6
4
11
3
Q
1
4
12
2
R
5
4
10
7

Solution: E (Rp) = Rf + σp ((Rm – Rf) / σm)
Portfolio P:
= 4 + 6((11 - 4) / 3)
= 18%
Portfolio Q:
= 4 + 1((12 - 4) / 2)
= 8%
Portfolio R:
= 4 + 5((10 -4) / 7)
= 8.29%

Portfolio P has higher expected return in comparison to portfolio Q and R.

Comments

  1. Phani KumarJune 20, 2020 4:08 pm

    Hey, thanks for the information. your posts are informative and useful. I am regularly following your posts.
    EBITDA

    ReplyDelete
  2. JenniferJune 26, 2020 2:21 pm

    Thanks for sharing this valuable information its really helps me in my study also.
    https://www.googlesir.com/assumptions-capital-asset-pricing-model-capm/

    ReplyDelete

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