Capital Market line

PREPARED BY :

DR. HANAN BARAKAT

CAL Vs. CML
 The line of possible portfolio risk and return combinations given the risk-free rate and the
risk and return of a portfolio of risky assets is referred to as the capital allocation line
(CAL). For an individual investor, the best CAL is the one that offers the most preferred
set of possible portfolios in terms of their risk and return. In other words, offers the
investor the greatest expected utility.

 If each investor has different expectations about the expected returns of, standard
deviations of, or correlations between risky asset returns, each investor will have a
different optimal risky asset portfolio and a different CAL. A simplifying assumption
underlying modern portfolio theory (and the capital asset pricing model, which is
introduced later in this reading) is that investors have homogeneous expectations (i.e., they
all have the same estimates of risk, return, and correlations with other risky assets for all
risky assets). Under this assumption, all investors face the same efficient frontier of risky
portfolios and will all have the same optimal risky portfolio and CAL.
Capital Market Line
 The availability of a risk-free asset allows investors to build
portfolios with superior risk-return properties. By combining a risk-
free asset with a portfolio of risky assets, the overall risk and return
can be adjusted to appeal to investors with various degrees of risk
aversion.
 On a graph of return versus risk, the various combinations of a risky
asset and the risk-free asset form the capital allocation line (CAL).
In the specific case where the risky asset is the market portfolio, the
combinations of the risky asset and the risk-free asset form the
capital market line (CML).
Capital Market Line (Markowitz)

 The CML is about portfolios, it represent the expected return based on

total risk. The CML uses the () to measure the risk of the portfolios.
 The formula for the CML offers a precise way of calculating the return that
investor can expect for providing financial capital (RFR),and bearing units
of Total risk ) measured by Standard Deviation.
Determining the Optimal Risky Portfolio by Assuming Homogeneous
Expectations
Capital Market Line

 The CML connects the RFR and the Market portfolio or any other
portfolios that possess risky assets by a linear relationship.
 The investor can get a combination between a portfolio consisting of
a risk-free asset and a portfolio of a risky assets either it is the
market portfolio, or any other portfolio on this line.
 The investor can borrow(issue bonds) and choose a point higher
than the market portfolio, or the investor can lend part of his
money(buy Treasury stocks) and choose another point lower than the
market portfolio.
Capital Market Line

The investor can borrow and choose a point higher than the portfolio ,or the
investor can lend part ,of his money and choose another point lower than the
market portfolio.
Capital Market Line
 The introduction of a risk-free asset changes the Markowitz efficient frontier
into a straight line. This straight efficient frontier line is called the capital
market line (CML). Investors at point Rf have 100% of their funds invested in
the risk-free asset. Investors at point M have 100% of their funds invested in
market portfolio M. Between Rf and M, investors hold both the risk-free asset
and portfolio M. To the right of M, investors hold more than 100% of portfolio
M. All investors have to do to get the risk and return combination that suits
them is to simply vary the proportion of their investment in the risky portfolio
M and the risk-free asset.
CML
 All the portfolios on the CML have a positive correlation with the market portfolios,
and so the assumption of the elimination of unsystematic risk is also applied on it,So
measuring the total risk by standard deviation ,while not considering unsystematic
risk, is considered a drawback in the CML.
 However, Any other portfolios not in the same line of the CML, do not have full
diversification at some degree ,and thus the portfolio has some unsystematic risk in
addition to systematic risk. Therefore the importance or need for diversifying is
vital.
 As more securities is added to the portfolio ,the lower Average covariance for the
portfolio, Thus the better the diversification and so the lower the unsystematic risk.
CML with different lending and
Borrowing rates
 Note that we identify the CML and CAL as lines even though they are a combination
of two assets. Unlike a combination of two risky assets, which is usually not a straight
line, a combination of the risk-free asset and a risky portfolio is a straight line, as
illustrated below by computing the combination’s risk and return.
 Risk and return characteristics of the portfolio represented by the CML can be
computed by using the return and risk expressions for a two-asset portfolio:
By definition, the standard deviation of the risk-free asset is zero. Because
its risk is zero, the risk-free asset does not co-vary or move with any other
asset.
CML Equation
 Under the assumption of homogeneous expectations, this optimal CAL for all
investors is termed the capital market line (CML). Along this line, expected
portfolio return, E(RP), is a linear function of portfolio risk, σP . The equation of
this line is as follows:

 The y-intercept of this line is Rf and the slope (rise over run) of this line is as
follows:
CML Equation

 Note that the expression is in the form of a line, y = a + bx. The y-intercept is
the risk-free rate, and the slope of the line referred to as the market price of
risk is [E(Rm) – Rf]/σm.
 The CML has a positive slope because the market’s risky return is larger than
the risk-free return. As the amount of the total investment devoted to the
market increases—that is, as we move up the line—both standard deviation
(risk) and expected return increase.
CML Equation Cont’.
 The intuition of this relation is straightforward. An investor who chooses to take
on no risk (σP = 0) will earn the risk-free rate, Rf. The difference between the
expected return on the market and the risk-free rate is termed the market risk
premium.

we can see that an investor can expect to get one unit of market risk premium in additional
return (above the risk-free rate) for every unit of market risk, σ M, that the investor is willing
to accept
Leveraged Portfolios :
This means that there is a negative investment in the risk-free asset, which is referred to as a leveraged
position in the risky portfolio. The particular point chosen on the CML will depend on the individual’s
utility function, which, in turn, will be determined by his risk and return preferences.
Capital Asset Pricing Model “CAPM”

 Capital Asset pricing Model (CAPM) is a proposed model by Sharpe

(1964) and Lintner (1965) and was developed in order to determine the
required rate of return by investors. This model is based on Markowitz’s
portfolio theory (1952), and it entails that investors should be compensated
for bearing higher systematic risk only and should not be compensated for
assuming any Unsystematic risk.

 This model gives us the expected rate of return investors require on the
company’s existing assets and operations and also the expected return they
will require on new investments that do not change the company’s market
risk
CAPM
 This model is an extension of Markowitz Theory , and both theories
combined together lead to the Capital Market Theory, that was named by
Sharpe.
 Given that Sharpe simplified some assumptions to Markowitz Theory
such as:
1- There is a Risk-Free Asset.
2- There is Linear relationship between risk and return.
3-Total risk is divided into two types of risk: Systematic and Unsystematic.
4- The Market index is used as a proxy for the Market portfolio.
CAPM Assumptions (Markowitz
assumptions+ additional assumptions)
 Investor’s Objective is to maximize the utility of Terminal
wealth.
 Investors make choices on the basis of Risk and Return.
 Investors have homogenous expectations of risk and return.
 Investors have identical time horizon.
 There are no taxes or transaction cost involved in buying or
selling assets
 There is an efficient market where all information is free and
available to investors.
CAPM Assumptions Cont.

 All investments are infinitely divisible, which means that it is possible to

buy or sell fractional shares of any asset or portfolio.
 There is no inflation or any change in interest rates, or inflation is fully
anticipated.
 There is a Risk-free asset , and investors can borrow and lend unlimited
amount at the Risk-Free rate “RFR”.
 Equilibrium Capital Market.
 There is a separation between investment and Financing theory.
Capital Asset Pricing Model(CAPM)
 In order to get the cost of Equity or the required rate of return, the Capital Asset
Pricing Model is used to set the basis for the asset pricing, it determines the rates
of expected return based on systematic risk. In other words, The CAPM indicates
what should be the expected or required rates of return on risky assets.

Ra =Rf + (Rm-Rf)
Ra=Required rate of return

Rf =Risk free rate

Β = Beta of security

Rm = Expected Market Return

Systematic Risk and Nonsystematic
Risk
 Sharpe has developed the Capital Asset pricing Model (CAPM) and divided total risk, into
systematic risk and unsystematic risk
 Systematic risk, also known as non-diversifiable or market risk, is the risk that affects the entire
market or economy. In contrast, nonsystematic risk is the risk that pertains to a single company or
industry and is also known as company-specific, industry-specific, diversifiable, or
idiosyncratic risk.
 Total variance = Systematic variance + Nonsystematic variance
 total risk (as measured by standard deviation) total risk = systematic risk + unsystematic risk
 Systematic or non-diversifiable risk is priced and investors are compensated for holding assets or
portfolios based only on that investment’s systematic risk. Investors do not receive any return for
accepting nonsystematic or diversifiable risk. Therefore, it is in the interest of risk-averse investors
to hold only well-diversified portfolios.
 One important conclusion of capital market theory is that equilibrium security returns depend on a
stock’s or a portfolio’s systematic risk, not its total risk as measured by standard deviation .
Systematic vs Unsystematic risk
Beta Coefficient
 Beta coefficient is the sensitivity for the individual investment
return to the changes of market return.
 The beta coefficient for market portfolio represented by market
index=1
 Ifindividual investment > Beta, so the level of risk is greater than
the average of market risk (Aggressive investment)
 If Beta is less than 1,So the risk is lower than the average market
risk (Defensive investment).
 If +ve Beta then changes in thee investment is in the same
direction for changes in Market returns and vice versa if –ve.
Beta formula: Calculation and Interpretation of Beta Because systematic risk
depends on the correlation between the asset and the market, we can arrive at a measure of
systematic risk from the covariance between Ri and Rm, where Ri is defined using the above
equation.
Portfolio Beta
 In order to calculate the beta for the portfolio, we take
the weighted average of beta for each stock.
 Beta port =

 Wi=Weights for the stocks inside the portfolio

 Bi= Beta for each stock.
 Portfolio Beta and Return
 You invest 20 percent of your money in the risk-free asset, 30 percent in the market portfolio, and 50
percent in redhat, a US stock that has a beta of 2.0. Given that the risk-free rate is 4 % and the market
return is 16 %, what are the portfolio’s beta and expected return?

 The beta of the risk-free asset = zero, the Beta of the Market = 1,and beta of Redhat is 2.0.The
portfolio beta is
 Bp= W1B1 +W2B2 + W3B3
=(0.2 * 0) + (0.3 * 1 ) + (0.5* 2) = 1.3
E(Ri) = Rf + B (E(Rm)-Rf)
0.4 + 1.3 * (0.16 – 0.04 ) = 0.196 =19.6%
Example on Estimating Cost of Equity
(RRR) by using CAPM
 Big Oil’s common stock beta is estimated at 0.85,the risk-free
interest rate of rf is 6 %,and the expected market premium (Rm-Rf) is
7 %,Then the CAPM would put Big oil’s cost of equity at:

Cost of equity = Rf + ( Rm- Rf )

= 6% + 0.85 (7 %)
= 12 %