Capital market line (CML)

Description

Capital market line (CML) is the tangent line drawn from the point of the risk-free asset to the feasible region for risky assets. The tangency point M represents the market portfolio, so named since all rational investors (minimum variance criterion) should hold their risky assets in the same proportions as their weights in the market portfolio.

The CML results from the combination of the market portfolio and the risk-free asset (the point L). All points along the CML have superior risk-return profiles to any portfolio on the efficient frontier, with the exception of the Market Portfolio, the point on the efficient frontier to which the CML is the tangent. From a CML perspective, the portfolio M is composed entirely of the risky asset, the market, and has no holding of the risk free asset, i.e., money is neither invested in, nor borrowed from the money market account. Points to the left of and above the CML are infeasible, whereas points to the right/below are attainable but inefficient.

Addition of leverage (the point R) creates levered portfolios that are also on the CML.

Related formulas

Variables

Erexpected return on security (dimensionless)
Rfrisk-free rate (dimensionless)
σvolatility (dimensionless)
ErMexpected return on market portfolio M (dimensionless)
σMvolatility on market portfolio M (dimensionless)