Question

1. Please explain the concept of Capital Market Theory. What is the new component into the old Markowitz’s efficient frontier? Explain the new way to select the optimal portfolio under the capital market theory.

Answer 1

The capital market line (CML) represents portfolios that optimally combine risk and return. Capital asset pricing model (CAPM), depicts the trade-off between risk and return for efficient portfolios. It is a theoretical concept that represents all the portfolios that optimally combine the risk-free rate of return and the market portfolio of risky assets. Under CAPM, all investors will choose a position on the capital market line, in equilibrium, by borrowing or lending at the risk-free rate, since this maximizes return for a given level of risk.

KEY TAKEAWAYS

• The capital market line (CML) represents portfolios that optimally combine risk and return.
• CML is a special case of the CAL where the risk portfolio is the market portfolio. Thus, the slope of the CML is the sharpe ratio of the market portfolio.
• The intercept point of CML and efficient frontier would result in the most efficient portfolio called the tangency portfolio.
• As a generalization, buy assets if sharpe ratio is above CML and sell if sharpe ratio is below CML.

The Capital Market Line Equation

Portfolios that fall on the capital market line (CML), in theory, optimize the risk/return relationship, thereby maximizing performance. The capital allocation line (CAL) makes up the allotment of risk-free assets and risky portfolio for an investor. CML is a special case of the CAL where the risk portfolio is the market portfolio. 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. The intercept point of CML and efficient frontier would result in the most efficient portfolio, called the tangency portfolio.

The CAPM, is the line that connects the risk-free rate of return with the tangency point on the efficient frontier of optimal portfolios that offer the highest expected return for a defined level of risk, or the lowest risk for a given level of expected return. The portfolios with the best trade-off between expected returns and variance (risk) lie on this line. The tangency point is the optimal portfolio of risky assets, known as the market portfolio. Under the assumptions of mean-variance analysis – that investors seek to maximize their expected return for a given amount of variance risk, and that there is a risk-free rate of return – all investors will select portfolios which lie on the CML