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The capital market line is a line used in graphs produced under the capital asset pricing model. It is the intersection between returns from investments that carry no risk and returns from the entire market. The capital market line differs from the better-known "efficient frontier" by including the no-risk investments.
The idea of the capital asset pricing model is to work out what rate of return is needed from an asset to make it worth adding to a portfolio. This takes account of the risk associated with that asset, specifically the element of that risk that cannot be mitigated through diversification. This risk covers factors such as losing money through the effects of inflation or currency exchange rate fluctuations.
The model uses a formula that takes into account the expected return on the asset, the return that could be achieved without risk through investments such as government bonds, the expected return on the market, and the way in which these three factors are expected to interact. While the formula appears complex, the results are clear when displayed on a graph that plots risk against return. The risk is listed as a "beta," meaning a figure of more than one shows above-average risk and below one shows below-average risk. The resulting graph makes it easy to compare the price and anticipated return of an asset against its risk to see if the investment makes sense on paper. The line plotted on the graph is known as the security market line.
The same graph can be used to look at the entire market. This is done by plotting the point for each individual asset where the return-to-risk ratio is highest. Joining together these points produces a line, usually a curve, that is known as the efficient frontier.
The capital market line is designed to allow the investor to consider the risks of an added asset in the context of his existing portfolio. This is done by first plotting a security market line and the efficient frontier curve for the same market. The capital market line then runs between the point where the efficient frontier intercepts the security market line, and the point at which the expected return on the asset is the same that could be achieved from a risk-free investment. The theory is that all points on the capital market line represent the best possible value combination of risk and return. This is because they offer better value than the market as a whole, but also offer better value than simply investing in risk-free assets.
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