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Capital Market Line (CML)

The line from the risk-free rate through the optimal portfolio.

The Capital Market Line shows the risk-return trade-off for efficient portfolios that combine the risk-free asset with the tangency portfolio. Points on the CML represent the best possible risk-return combinations achievable by mixing cash and the optimal risky portfolio.

Formula
E[r]=rf+E[rm]−rfσm⋅σE[r] = r_f + \frac{E[r_m] - r_f}{\sigma_m} \cdot \sigma
Where
E[r]E[r]=Expected return
rfr_f=Risk-free rate
E[rm]E[r_m]=Expected market return
σm\sigma_m=Market volatility
σ\sigma=Portfolio volatility
Variables
E[R]Expected return on CML portfolio
R_fRisk-free rate
E[R_m]Expected return of tangency portfolio
\sigma_mVolatility of tangency portfolio
\sigmaTarget portfolio volatility
Assumptions
  • Investors can borrow/lend at the risk-free rate
  • No transaction costs or taxes
  • All investors have homogeneous expectations
Related Terms

Efficient Frontier

The set of portfolios offering the highest return for each level of risk.

Maximum Sharpe Portfolio

The portfolio with the highest risk-adjusted return.

Sharpe Ratio

Risk-adjusted return: excess return divided by volatility.