As such, the points on the upward sloping portion of the portfolio frontier represent portfolios that investors find attractive, while points on the downward sloping portion represent portfolios that are inefficient. Therefore, all portfolios should have a Sharpe ratio less than or equal to the market's. This represents the allocation between the risk-free asset and the risk asset based on investor risk preferences. The same graph can be used to look at the entire market. The risk-return characteristics for the potential risk asset portfolios can be plotted to generate a Markowitz efficient frontier.
This takes account of the risk associated with that asset, specifically the element of that risk that cannot be mitigated through diversification. On the other hand, unsystematic risk is risk to which only specific classes of securities or industries are vulnerable. This type of risk is inherent in all marketable securities and cannot be diversified away. An investor is only willing to accept higher risk if the return rises proportionally. If investor is rational and risk-averse it will accept higher risk only when return increase proportionally. Both the lines in the above graphs representing the combination of risk-free asset and Portfolio C and risk-free asset and Portfolio D are capital allocation lines. It is a special case of capital allocation line that is tangent to the efficient frontier and the slope of the capital allocation line represents the Sharpe ratio.
So, the graph shown on actual values of betas, and expected returns of stocks look like a set of points rather than a single line. It is called the capital market line and it is the best possible way in which the risk-free rate and a portfolio of risky assets can be mixed. All those portfolios give the highest return for the amount of risk an investor is willing to take - or defined in another way, have the lowest risk for the return to be achieved. If such is the case, then all investors would prefer A to B. But the investor, who maintains a diversified portfolio of different stock, has already eliminated the company specific risk portion of the total risk. The steeper the capital allocation line, the higher the expected return investors receive in exchange for taking risk. The slope of the line, S p , is called the Sharpe Ratio The Sharpe Ratio is a measure of risk adjusted return comparing an investment's excess return over the risk free rate to its standard deviation of returns.
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. It shows all the possible asset allocations available to the investor. When we combine a risky asset portfolio with a risk-free asset, we form a capital allocation line. The following table shows the expected return and standard deviation of Portfolio B and D: Portfolio Portfolio Standard Deviation Portfolio Expected Return B 4. Complete portfolio and capital allocation line In constructing portfolios, investors often combine risky assets with risk-free assets such as government bonds to reduce risks. Since 2009 he has published two books and numerous articles, both online and in print.
The capital market line is, graphically, a tangent line that can be drawn on a graph, connecting the return of risk-free-asset with the efficient market frontier. It is based on the expected rate of return on the market, the risk-free rate and the beta coefficient of an individual security or portfolio. Passive and Active Portfolios If the market is informationally efficient, then the quoted price of a security in the market is an unbiased estimate of all the future discounted cash flows and reflects all publicly known information about the security. Unlike the Capital Market Line, the Security Market Line shows the expected returns of individual assets. The model describes the relationship of the expected rate of return as a function of the risk free interest rate, the investment's beta, and the expected market risk premium. An instrument plotted above the line has a high expected return and a low price.
While the Capital Market Line graphs define efficient portfolios, the Security Market Line graphs define both efficient and non-efficient portfolios. Finally, if we invest everything in the portfolio of stocks, we earn the expected return of the risky asset. The Sharpe ratio measures the increase in expected return per unit of additional standard deviation. A beta of one is exactly even with the market. A complete portfolio is defined as a combination of a risky asset portfolio, with return R p , and the risk-free asset, with return R f.
On the x-axis market risk is shown in form of beta risk. The idea is that all investors all investors agree to common expectations for all assets, i. This can be based on past market return by using the data from the beta calculation or just an educated guess based on your knowledge of the market and economy. It illustrates the concept that it is possible to obtain any combination of risk and expected return along the slope of the graph by investing some portion of your investment in the market portfolio and borrowing the rest. According to the mean-variance criterion, any investor would optimally select a portfolio on the upward sloping portion of the portfolio frontier, which is called the efficient frontier , or minimum variance frontier.
Capital market line is a pre-cursor to the. The rational investor will require either a higher return or lower price, which will both result in a higher cost of capital for the company. The Security Market Line is useful for determining whether an investment in an asset offers a good expected return for the risk taken. 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. You might want to review the article on to obtain an understanding of the portfolio expected return, portfolio standard deviation and their interplay using the efficient frontier. Type the beta value of 0 into cell C2, type the value of 1 into cell C3.