Preview

CML Derivation

Powerful Essays
Open Document
Open Document
1392 Words
Grammar
Grammar
Plagiarism
Plagiarism
Writing
Writing
Score
Score
CML Derivation
Q5
How the CML is derived?
The line of possible portfolio risk and return combinations given the risk-free rate, risk and return of a portfolio of risky assets is referred to as the capital allocation line (CAL).

A simplifying assumption underlying modern portfolio theory 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.

Under the assumption of homogeneous expectations, this optimal CAL for all investors is termed the capital market line (CML).

A line used in the capital asset pricing model to illustrate the rates of return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio.

The CAPM is a model for pricing an individual security or a portfolio

expected return = risk-free rate + portfolio beta* (the difference between the expected return on the market as a whole and the risk-free rate).

Efficient frontier:

Efficient frontier is the set of portfolios among all the possible portfolios of combinations of individual risky assets that offers the highest expected return for each level of risk (standard deviation

The concept of an efficient frontier can be used to illustrate the benefits of diversification. An undiversified portfolio can be moved closer to the efficient frontier by diversifying it. Diversification can, therefore, increase returns without increasing risk, or reduce risk without reducing expected returns.
The assumptions:

The assumptions of Capital Market theory are primarily eightfold and I will attempt to explain them below. 1. Everyone is an Efficient Investor – It goes without saying that everyone wants to be a efficient investor. No investor wants economic loss and all

You May Also Find These Documents Helpful

  • Powerful Essays

    740hw

    • 1215 Words
    • 8 Pages

    additional descriptor of risk, and will be associated with abnormal returns if the CAPM is used…

    • 1215 Words
    • 8 Pages
    Powerful Essays
  • Powerful Essays

    Thompson Asset Management

    • 2102 Words
    • 14 Pages

    its returns, absolute and relative risks, as well as its risk relative to a benchmark index. The…

    • 2102 Words
    • 14 Pages
    Powerful Essays
  • Powerful Essays

    a. The Capital Asset pricing Model (CAPM) is an equilibrium asset pricing theory showing that equilibrium rates of expected return on all risky assets are a function of their covariance with the market portfolio. The CAPM is a single-index…

    • 1781 Words
    • 8 Pages
    Powerful Essays
  • Powerful Essays

    Eugene F, F., 1970. Efficient Capital Markets: A Review of THeory and Empirical Work. The…

    • 2606 Words
    • 11 Pages
    Powerful Essays
  • Satisfactory Essays

    An investor can allocate money between a risk-free security that has zero risk (β=0), and the market portfolio that has market risk (β=1). If 75% of the portfolio is invested in the market, then the portfolio will have a β=0.75. If only 25% is invested in the market, then the portfolio will have a market risk of β=0.25. The first example (β=0.75) might be taken by a less risk averse investor while the second example (β=0.25) illustrates the portfolio of a more risk averse investor. By allocating the investment money between 0 and 100% into the market portfolio, an investor can achieve any level of market risk desired.…

    • 519 Words
    • 3 Pages
    Satisfactory Essays
  • Good Essays

    Risk and Return

    • 6339 Words
    • 26 Pages

    The percentage of a portfolio’s total value invested in a particular asset is called that asset’s:…

    • 6339 Words
    • 26 Pages
    Good Essays
  • Best Essays

    Within any investment there is a certain amount of risk, which must be taken into account by an investor when deciding to invest. Risk is defined as the chance of financial loss or, more formally the variability of returns associated with a given asset. (Gitman, et al., 2011, p. 208) This concept in finance is the idea that all investment carries a risk, the higher the risk, the greater the return, however the adverse is also relevant, when the risk of an investment is lower the return is expected to also be lower. However, with all investment there is never a guarantee of return.…

    • 1262 Words
    • 6 Pages
    Best Essays
  • Powerful Essays

    CAPM results can be compared to the best expected rate of return that investor can possibly earn in other investments with similar risks, which is the cost of capital. Under the CAPM, the market portfolio is a well-diversified, efficient portfolio representing the non-diversifiable risk in the economy. Therefore, investments have similar risk if they have the same sensitivity to market risk, as measured by their beta with the market portfolio.…

    • 1337 Words
    • 6 Pages
    Powerful Essays
  • Better Essays

    McClure, B. (2010, November 24). The capital asset pricing model: An overview. Retrieved from http://www.investopedia.com/articles/06/CAPM.asp…

    • 1214 Words
    • 5 Pages
    Better Essays
  • Powerful Essays

    Portfolio Managementi

    • 1372 Words
    • 6 Pages

    1. The optimal portfolio is identified at the point of tangency between theefficient frontier and the…

    • 1372 Words
    • 6 Pages
    Powerful Essays
  • Good Essays

    asdf

    • 4824 Words
    • 20 Pages

    Therefore, beta was a measure of the market risk of PSC’s portfolio while alpha measured its expected return if market risk were eliminated…

    • 4824 Words
    • 20 Pages
    Good Essays
  • Good Essays

    Exam Paper

    • 965 Words
    • 4 Pages

    Suppose the relevant equilibrium model is the CAPM with unlimited borrowing and lending at the risk-free rate.…

    • 965 Words
    • 4 Pages
    Good Essays
  • Powerful Essays

    How to Use Capm?

    • 1510 Words
    • 7 Pages

    In a world where non-linearity and randomness are the norm, the capital asset pricing model (CAPM) is widely accepted despite it being a linear model, and this is probably due to the simplicity of the model and its pre-computer age birth (see equation below). A well recognized and utilized metric in finance is beta (β), which is the slope in the linear CAPM. To derive β one simply plots the returns (capital gains plus dividend yields) of an individual stock (y-axis) against the returns of a well diversified portfolio of stocks ( x-axis), with the resulting slope being called β. Thus β represents the risk associated with an individual stock, as it is compared to a well diversified portfolio, and since the market portfolio theoretically only contains market risk, a β above (below) one reflects the degree of company-specific risk of the individual stock that should be diversified away as it is added to the market portfolio.…

    • 1510 Words
    • 7 Pages
    Powerful Essays
  • Best Essays

    Capital Asset Pricing Model

    • 2370 Words
    • 10 Pages

    Andre F. Perold (2004). The Capital Asset Pricing Model. Journal of Economic Perspectives, Vol. 18, No.3, p.3-24.…

    • 2370 Words
    • 10 Pages
    Best Essays
  • Powerful Essays

    Capital Assed Pricing Model, widely known as CAPM is essentially an equilibrium relationship between expected return and risk of an asset and that is used in the pricing of risky securities. CAPM is the result of William Sharpe (1964) and John Lintner (1965). Sharpe took the Nobel prize in 1990 for the asset pricing theory. CAPM is used for a range of applications and purposes, these include estimating the cost of equity capitals for firms as well as evaluating the performance of managed portfolios. Sharpe and Lintner have made 2 underlying assumptions for developing CAPM;…

    • 1946 Words
    • 8 Pages
    Powerful Essays