Capital Market Line (CML) 🛣️💰

Until now, we assumed investors only choose between different stocks. But in the real world, you can also put your money in Risk-Free Assets (like Govt Treasury Bills). When we add this option, the Efficient Frontier changes from a curve into a straight line: the Capital Market Line (CML).

1. Defining the CML

The Capital Market Line represents the risk-return relationship for efficient portfolios (mix of the Market Portfolio and the risk-free asset).

• Intercept (Y-axis): The line starts at Rf (The Risk-Free Rate).
• Tangency Point: The line touches the Efficient Frontier at exactly one point: the Market Portfolio (M).

2. The CML Equation

The expected return of an efficient portfolio is:

Ep = Rf + [ (Rm - Rf) / Sm ] * Sp

Where:

• Ep: Expected return of the portfolio.
• Rf: Risk-free rate.
• Rm: Return of the market portfolio.
• Sm: Standard deviation (risk) of the market portfolio.
• Sp: Standard deviation of the chosen portfolio.

3. Separation Theorem

The CML leads to a revolutionary idea called the Separation Theorem:

1. Investment Decision: Regardless of your risk tolerance, you should always find the Market Portfolio (M).
2. Financing Decision: You then decide how much to put in "M" and how much to keep in Boring Bonds (Rf) based on your risk tolerance.

Summary

• The CML is the new Efficient Frontier when a risk-free asset exists.
• It is a straight line.
• Its slope represents the Price of Risk (Return per unit of risk).
• It separates the "Best Mix of Stocks" decision from the "How Much Risk" decision.

Quiz Time! 🎯

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