Capital Market Line Definition and Tutorial for Investment Modeling (2024)

The practice of asset allocation employed by millions of investment advisors worldwide originates from scholarly advancements in the 1960s.

Define - Define the Capital Market Line for investments.
Context - Use CML in a sentence.
Video - See the video for a thorough understanding.
Script - Follow along with the transcript below.
Quiz - Test yourself.

by Paul Alan Davis, CFA

Published: July 16, 2016

Updated: February 17, 2021

Even without formal training in financial theory, it's easy to understand the takeaways. It still helps to review the background.

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Capital Market Line

Intermediate

Capital Market Line is a theoretical concept from the Capital Asset Pricing Model used to derive investor allocations to two assets: a Risk-Free asset like a T-Bill and the Market Portfolio of risk assets. It connects the Risk-Free asset return on the y-axis to the Efficient Frontier at the Market Portfolio. Portfolio allocations below the Market Portfolio imply lending (or buying bonds) and above imply borrowing (using leverage) to buy additional positions of the Market Portfolio. Where the client's Indifference Curve meets the line is at the Optimal Portfolio.

Synonym: CML

For context, this theory provides a way to group all investable assets into two groups, "risk-free" and "risky". After setting expected returns for each, it becomes easy to grasp the trade-off between the two in terms of return and risk. That's why the Capital Market Line has had such an influential impact on how most people invest, whether they know it or not.

In a Sentence

Jim: My client understands the Capital Market Line and...
Ken: Sorry Jim, is says right here in our ADV, clients cannot use leverage.

Video

This video can be accessed in a new window or App , at our YouTube Channel, or from below.

Capital Market Line definition for investment modeling (5:19)

Video Script

The script includes two sections where we visualize and demonstrate the concept of the Capital Market Line.

Visualize

We're sitting in Excel, and this is a snippet from our boot camp course.

There we cover all of the curves, lines and dots shown here in one 40-minute video, but because most people can't sit still that long, we break it out into eleven 4-5 minute videos, just like this one. I'll provide a link to boot camp video if you'd like the whole story. (See the tutorial Ace Your Portfolio Theory Exam instead).

Ok, we have a chart, with expected return on the y-axis and expected risk on the x-axis. The 'expected' timeframe assumes we've taken 'historical' data as input, run a regression to generate 'expected' return and risk.

The curves and dots on the right represent advancements in Modern Portfolio Theory, covered elsewhere, and Capital Market Theory, or CAPM, developed in the 1960s, shifted the conversation to the left here.

Academic theories require that we hold other variables constant, with assumptions and here is a list of MPT assumptions to review later. We could tack on another set for Capital Market Theory and if you'd like more than this quick-and-dirty summary reach out to me for in-depth readings.

Demonstrate

Let's demonstrate and focus on this definition. The Capital Market Line connects the Risk-Free Asset return, rf2 on the y-axis, to the Efficient Frontier dark green curve, at the Market Portfolio, labeled M2 here. At rf2 an investor allocates 100% in Treasury Bills. At M2, the investor allocates 100% to the Market Portfolio. The investor wouldn't choose point A because she would get more bang for her buck where the line's slope is the steepest. Ponder that for a second.

Think about it this way, an investor seeking a higher return must take risk, and move up this line. Each step of the way adding risky assets 25%, 50%, 75%, 100%. Think about buying T-Bills just as if you are lending to the government. You could keep going, past M2 and have maybe 200% invested in the Market Portfolio, with 100% of borrowed money. That's a difficult concept, but is possible, yet uncommon.

Capital Market Theory demonstrated how investors could choose between these two assets exclusively, selecting an allocation that matches her tolerance for risk, thereby shifting this light green indifference curve, which was over here for the MPT examples, up and down the Capital Market Line. Risk-averse investors here, and risk-seeking investors here.

Quiz

Click box for answer.

If the risk-free rate was equal to the expected Market rate there would be no reason to invest in stocks? | True or False?

True, theoretically.

Questions or Comments?

Still unclear on the Capital Market Line? Leave a question in the comments section on YouTube or check out the Quant 101 Series, specifically Ace Your Portfolio Theory Exam.

Related Terms

Our trained humans found other terms in the category Capital Market Theory you may find helpful.

Capital Market Theory
Market Portfolio
Risk-free asset

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FAQs

Capital Market Line Definition and Tutorial for Investment Modeling? ›

The capital market line (CML) represents portfolios that optimally combine risk and return

risk and return
Risk-return tradeoff states that the potential return rises with an increase in risk. Using this principle, individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns.
https://www.investopedia.com › terms › riskreturntradeoff
Risk-Return Tradeoff: How the Investment Principle Works

. CML is a special case of the capital allocation line (CAL) where the risk portfolio is the market portfolio. Thus, the slope of the CML is the Sharpe ratio of the market portfolio.

What is the capital market line in investment? ›

Capital Market Line is a theoretical concept expressed in a graph representing portfolios that optimally combine risk and return. In terms of risk, it includes both the risk-free rate and the risk of the market portfolio and hence is considered better than the Efficiency Frontier, which only considers risky assets.

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What is the formula for the CML line? ›

This is in the form of an equation of a straight line where the intercept is R_f_, and the slope is E(Rm)–Rfσm E ( R m ) – R f σ m . This is the CML line which has a positive slope as the market return is greater than the risk-free return.

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How to find cml line? ›

The CML is determined using the Sharpe ratio of the market portfolio. A tangent line is drawn from the risk-free rate on the Efficient Frontier. Progressing upwards amplifies both risk and return while descending yields the converse effect.

What is an example of a capital market line? ›

Example of the Capital Market Line

Suppose an investor is considering two different investments, Stock A and Stock B. Stock A has an expected return of 10% and a beta of 1.5. Stock B has an expected return of 12% and a beta of 2.0. The CML can compare expected return and risk of these two stocks.

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What is the capital market theory in investment management? ›

Capital market theory makes reference to multiple forms of analysis that aim to predict the value of securities and the flow of supply and demand in the market. In this section, we'll discuss a model, theory, and hypothesis, all of which are considered integral components of capital market theory.

How do you calculate the expected returns by using CML? ›

We'll use the CML equation: Expected return = Rf + (Reward-to-risk ratio) × σp Plugging in the values: Expected return = 5% + (0.3684) × (7%) ≈ 7.58% The expected return on a well-diversified portfolio with a standard deviation of 7% is approximately 7.58%.

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What is the slope of the CML line? ›

Thus, the slope of the CML is the Sharpe ratio of the market portfolio. As a generalization, buy assets if the Sharpe ratio is above the CML and sell if the Sharpe ratio is below the CML. CML differs from the more popular efficient frontier in that it includes risk-free investments.

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How do you calculate security market line? ›

The formula for plotting the SML is required return = risk-free rate of return + beta (market return - risk-free rate of return).

How do I get a CML list? ›

Your demat broker sends you a physical copy as well as a soft copy of Client Master List/ Client Master Report (CML/CMR) at the time of account opening. You can just call/email your demat account broker asking for Client Master List and they will email you the pdf document.

How to graph a capital allocation line? ›

Constructing Portfolios With the CAL

These combinations are plotted on a graph where the y-axis is the expected return, and the x-axis is the risk of the asset as measured by the standard deviation. The simplest example is a portfolio with two assets: a risk-free Treasury bill and a stock.

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What is the difference between the security market line and the capital market line? ›

Don't confuse the Security Market Line with the Capital Market Line (CML)! They may seem similar, but there are key differences: The CML uses total risk on the x-axis, while the SML uses only systematic risk. Only efficient portfolios plot on the CML, while all properly priced assets and portfolios plot on the SML.

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What is the capital market line and characteristic 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 market's risk and return at a given time.

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Why is the capital market line straight? ›

The Capital Market Line (CML) is a straight line that begins at the risk-free rate and ends at the highest possible expected return for any given risk level. The line shows the required expected return for every possible level of risk and the risk-return ratio (the slope) is determined by the market portfolio.

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What does the capital market line use as a risk measurement? ›

Risk Measurement: The CML uses total risk (standard deviation), while the SML employs systematic risk (beta). Application: The CML pertains to efficient portfolios, whereas the SML relates to individual securities.

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What is an equity market vs capital market? ›

The stock market deals only with equity capital, while the capital market deals with equity and debt instruments. The stock market exclusively works with corporations regulated by the Securities Exchange Commission (SEC), while the capital market extends beyond regulated securities.

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