CAPITAL MARKET LINE

CAPITAL MARKET LINE

James Tobin (1958) expanded on

Markowitz's work by adding a risk-free
asset to the analysis.
This lead to the notions of a super-
efficient portfolio and the capital market
line.
 CAPITAL MARKET LINE

By combining a risk-free asset with a

portfolio on the efficient frontier, it is
possible to construct portfolios whose
risk-return profiles are superior to those
of portfolios on the efficient frontier.
PORTFOLIOS OF ONE RISKY ASSET AND A RISK-
FREE ASSET

Its possible to split investment funds between

safe and risky assets.
Risk free asset: proxy; T-bills
Risky asset: stock (or a portfolio)
 WHAT IF ONE CAN INVEST IN THE RISK-FREE
ASSET?
If we add the risk-free asset to N risky assets,
we can enhance the efficient frontier (EF) to
the red line shown in the previous figure, i.e.,
the straight line that passes through the risk-
free asset and the tangent point of the
efficient frontier (EF).
Let us called this straight line enhanced
efficient frontier (EEF).
EFFICIENT FRONTIER
 RISK FREE BORROWING AND
LENDING
Risk free borrowing and lending means
borrowing and lending at rf (risk- free
rate)
 RISK FREE BORROWING AND
LENDING
When you add a risk free security to your
efficient portfolio, you are lending money
to the issuer at risk free rate.
 RISK FREE BORROWING AND LENDING

When you borrow money( take loan) at risk-

free rate (of interest) and invest more in a
risky efficient portfolio, you are doing risk
free borrowing
 Capital Allocation Line

Risk free lending and borrowing change the

shape of the efficient frontier to a straight line
since risk-free asset has zero correlation with
any combination of risky securities.
When one of the two investments is risk-free,
the combination line is always a straight line
 Capital Allocation Line
Thus, standard deviation of a portfolio that
consists of a combination of risk-free and
risky-assets is the linear proportion of the
standard deviation of the risky asset portfolio.
Several combinations of expected return-
standard deviation can be obtained by
creating such portfolios.
The line joining all such combinations is called
the Capital Allocation Line (CAL).

2016 Cengage Learning India Pvt. Ltd. All

rights reserved.
 Capital Allocation Line
All points along CAL represent investment
opportunity set which is a collection of feasible
combinations of portfolios of risky and risk-free
assets obtained by changing the value of x.
The slope of CAL measures the incremental
return for incremental risk, i.e., increase in
expected return per unit rise in standard
deviation. For this reason it is called reward to
volatility ratio or Sharpes ratio.
2016 Cengage Learning India Pvt. Ltd. All
rights reserved.
 Capital Allocation Line
Different combinations of risk-free assets with
risky portfolio along the efficient frontier can
yield many capital allocation lines (CAL).

2016 Cengage Learning India Pvt. Ltd. All

rights reserved.
 2016 Cengage Learning India Pvt. Ltd. All
rights reserved.
 CAPITAL MARKET LINE

CAL which is tangential to the old efficient

frontier is called Capital Market Line (CML). It
has highest Sharpe ratio as compared to other
CALs
EFFICIENT PORTFOLIO WITH
LENDING AND BORROWING

Rp

M
D

RF
A

p
Rp CML

M
D

RF
A

Capital Market Line

 CAPITAL MARKET LINE

The point of tangency (M) i.e. the

point at which CML touches the old
efficient frontier is referred to as
MARKET PORTFOLIO.
 MARKET PORTFOLIO
Market portfolio contains every risky
security in the proportion of its market
value to the aggregate market value of all
assets
 MARKET PORTFOLIO
Example

Let's say the entire world financial market consists of three stocks: those of

Company A, Company B and Company C.

Company A's market capitalization is Rs. 1 billion

Company B's market capitalization is Rs. 2 billion

Company C's market capitalization is Rs. 3 billion

The total market portfolio would then consist of the following:

17% Company A stock (1 billion / 6 billion)

33% Company B stock (2 billion / 6 billion)

50% Company C stock (3 billion / 6 billion)

 Optimal Risky Portfolio

The basic aim of constructing a portfolio is to

achieve the objective of maximization of
returns for a given level of risk or minimization
of risk for a given level of return.
A portfolio of risky assets that helps us
achieve this objective is called optimal risky
portfolio.
 Optimal Risky Portfolio

It is a portfolio that dominates all other

portfolios. Optimal risky portfolio combines
the risky assets in certain specific proportions.
In investment management, a portfolio of
risky assets is considered optimal when the
asset proportions are such that a measure
called Sharpes ratio is maximized.
 Risk Free Lending

Rp

C
B
D
O
RF

p
RISK-RETURN MEASURES FOR THE MIXED PORTFOLIO

Rp = X RM + (1-X)RF
EXPECTED STANDARD DEVIATION OF
THE PORTFOLIO

p = XM
 Risk Free Borrowing

Rp

C
B
D

p
Risk-return Measures for the Mixed
Portfolio

Rp = X RM - (X-1)RF
Expected Standard Deviation of the
Portfolio

p = Xp
 The Capital Market Line

In an efficient capital market investors will require

a return on a portfolio that compensates them for
the risk-free return as well as the market price for
risk.
This means that portfolios should offer returns
along the CML.

9 - 29
 Capital Allocation Line
All points along CAL represent investment
opportunity set which is a collection of feasible
combinations of portfolios of risky and risk-free
assets obtained by changing the value of x.
The slope of CAL measures the incremental
return for incremental risk, i.e., increase in
expected return per unit rise in standard
deviation. For this reason it is called reward to
volatility ratio or Sharpes ratio.
2016 Cengage Learning India Pvt. Ltd. All
rights reserved.
 Capital Allocation Line
Different combinations of risk-free assets with
risky portfolio along the efficient frontier can
yield many capital allocation lines (CAL).
If a portfolio lies on best feasible CAL, its
Sharpes ratio is equal to the Sharpes ratio of
the optimal risky portfolio.

2016 Cengage Learning India Pvt. Ltd. All

rights reserved.
 2016 Cengage Learning India Pvt. Ltd. All
rights reserved.
 CAPITAL MARKET LINE
Implication for investors:
Regardless of the level of risk-aversion, all investors should
hold only two securities:
The market portfolio
The risk-free asset
Conservative investors will choose a point near the lower
left of the CML
Growth-oriented investors will stay near the market
portfolio
Optimal Complete Portfolio
Point P where the
CAL is tangent to
the efficient frontier
depicts the optimal
risky portfolio
At Points 1 and 2
the indifference
curves of 2 different
investors are tangent
to the CAL
Points 1 and 2
depict the
Optimum
complete portfolio
for those investors
 Summary
Note that optimal risky portfolio is the same for all investors
Formula for computation of weights of optimal risky portfolio does not
include the investors degree of risk aversion
Hence the fund manager will offer the same optimal risky portfolio
to all his investors- his job becomes easier !
The optimal complete portfolio for each investor (the allocation
of funds between the risky portion and risk-free portion) will be
different
It will depend on investors preferences, i.e. his degree of risk
aversion and indifference curve
More risk averse investors will have lower proportion of the
optimal risky portfolio in their complete portfolio than less risk-
averse investors
 Decision to add a new asset
When a new asset X is to be added to an
existing well-diversified portfolio P we require
Sharpe ratio of new asset X
Sharpe ratio of existing portfolio
Correlation of asset X with existing portfolio
If Sharpe ratio of X > Sharpe ratio of
Portfolio* Correlation of X and P
 Portfolio theory in real life, I
Portfolio theory is probably the mostly used modern financial
theory in practice.
The foundation of asset allocation in real life is built on
portfolio theory.
Asset allocation is the portfolio optimization done at the asset
class level. An asset class is a group of similar assets.
Virtually every fund sponsor has an asset allocation plan and
revises its asset allocation annually.
 Portfolio theory in real life, II
Portfolio managers often use a quadratic program to generate the efficient
frontier (or enhanced efficient frontier) and then choose an optimal
portfolio on the efficient frontier (or enhanced efficient frontier).
Many commercial computer packages, e.g., Matlab, have a built-in
function for quadratic programming.
This calculation requires at least two sets of inputs (estimates): expected
returns and covariance matrix of asset classes.
The outputs from the optimization include portfolio weights for asset
classes. Asset allocation is based on these optimized portfolio weights.