Economics Risk And Return Questions Medium
The Capital Market Line (CML) is derived by combining the risk-free rate of return with the efficient frontier of risky assets. The efficient frontier represents the set of portfolios that offer the highest expected return for a given level of risk.
To derive the CML, we start by plotting the risk-free rate of return on the y-axis and the standard deviation (a measure of risk) on the x-axis. The risk-free rate represents the return an investor can earn with certainty, typically by investing in government bonds or other low-risk assets.
Next, we plot the efficient frontier, which is a curve that represents the optimal portfolios that offer the highest expected return for each level of risk. These portfolios are constructed by combining different proportions of risky assets, such as stocks or bonds, in a diversified manner.
The CML is then derived by drawing a straight line from the risk-free rate of return to the point where it tangentially intersects the efficient frontier. This tangency point represents the optimal portfolio that offers the highest expected return for a given level of risk. The slope of the CML represents the risk premium, which is the additional return an investor can expect to earn for taking on additional risk beyond the risk-free rate.
In summary, the Capital Market Line is derived by combining the risk-free rate with the efficient frontier of risky assets, and it represents the optimal portfolio that offers the highest expected return for each level of risk.