CAL:

All the points on the Capital Allocation Line are combinations of

[a] The risk free rate

[b] A portfolio of risky assets

Whether your overall portfolio is 10% invested in rf and 90 % in a risky portfolio

or the other way around depends on your preferences and risk tolerance /
objectives.

Your CAL will be different from mine (has a different slope) because we have
different risk preferences and objectives.

I may be more risk averse than you and invest 20 % in rf and 80 % in a risky
portfolio. Hence we will draw different CALs.

Your risky portfolio will be different from mine.

CML:

If you impose a set of conditions on the CAL such as homogeneous expectations

with respect to E(r) and risk of asets across ALL MARKET PARTICIPANTS you
will get the CML.
While the CAL is a combination of the rf and a risky portfolio which varies across
individuals, the CML is a combination of the rf and the tangency portfolio (market
portfolio).

All the points on the CAL are combinations of the rf and a risky portfolio which
varies from person to person according to his/her risk preferences.

All the points on the CML are combinations of the rf and market portfolio which is
the same for each person.

Whether you invest 10 % in rf and 90 % in market portfolio depends again on

indivifual risk preferences BUT the market portfolio is the same for EVERYONE.

There is another way to understand the CML : It is the efficient frontier in a

universe where you can invest in risky stocks and the rf asset.

If you can only invest in risky assets : the efficient frontier is the upper portion of
the minium variance frontier. All points on the efficinet frontier are combinations
of risky assets that generate the highest return for a given level of risk.

if you can invest in risky assets and the rf asset : the efficient frontier is the CML.
Remember, the CML connects the rf asset with the risky (market) portfoliohence
all the points on this line segment are combinations of the rf and the market
portfolio.

SML :
Graphical representation of the notion embodied in the CAPM, that expected asset
returns are linearly related to systematic risk. The greater the systematic risk (Beta)
-> the greater the expected return to a risky asset.

This is due to the fact that investors need to be compensated for assuming more
systematic risk, the kind of risk that cannot be diversified away by holding a
portfolio of diverse assets (i.e.assets that have a less than +1 correlation).

The SML is a simple tool for determining whether an asset offers reasonable
expected return for the systematic risk it entails.

A security plotting above the SML is undervalued ( its return is higher than it
should be given its systematic risk implying that its price is lower than it should
be )

A security plotting below the SML is overvalued (its return is lower than it should
be given its systematic risk implying that its price is higher than it should be )

Also remember : the risk measure used by CAL/CML is the standard deviation of
asset returns while that used by the SML is the systematic risk
CML vs SML

CML stands for Capital Market Line, and SML stands for Security Market Line.
The CML is a line that is used to show the rates of return, which depends on risk-
free rates of return and levels of risk for a specific portfolio. SML, which is also
called a Characteristic Line, is a graphical representation of the markets risk and
return at a given time.
One of the differences between CML and SML, is how the risk factors are
measured. While standard deviation is the measure of risk for CML, Beta
coefficient determines the risk factors of the SML.
The CML measures the risk through standard deviation, or through a total risk
factor. On the other hand, the SML measures the risk through beta, which helps to
find the securitys risk contribution for the portfolio.
While the Capital Market Line graphs define efficient portfolios, the Security
Market Line graphs define both efficient and non-efficient portfolios.

While calculating the returns, the expected return of the portfolio for CML is
shown along the Y- axis. On the contrary, for SML, the return of the securities is
shown along the Y-axis. The standard deviation of the portfolio is shown along
the X-axis for CML, whereas, the Beta of security is shown along the X-axis for
SML.

Where the market portfolio and risk free assets are determined by the CML, all
security factors are determined by the SML.
Unlike the Capital Market Line, the Security Market Line shows the expected
returns of individual assets. The CML determines the risk or return for efficient
portfolios, and the SML demonstrates the risk or return for individual stocks.

Well, the Capital Market Line is considered to be superior when measuring the risk
factors.

Summary:
1. The CML is a line that is used to show the rates of return, which depends on
risk-free rates of return and levels of risk for a specific portfolio. SML, which is
also called a Characteristic Line, is a graphical representation of the markets risk
and return at a given time.

2. While standard deviation is the measure of risk in CML, Beta coefficient

determines the risk factors of the SML.

3. While the Capital Market Line graphs define efficient portfolios, the Security
Market Line graphs define both efficient and non-efficient portfolios.

4. The Capital Market Line is considered to be superior when measuring the risk
factors.

5. Where the market portfolio and risk free assets are determined by the CML, all
security factors are determined by the SML.

The Capital Asset Pricing Model

In finance, one of the most important things to remember is that return is a function
of risk. This means that the more risk you take, the higher your potential return
should be to offset your increased chance for loss.
One tool that finance professionals use to calculate the return that an investment
should bring is the Capital Asset Pricing Model which we will refer to
as CAPM for this lesson. CAPM calculates a required return based on a risk
measurement. To do this, the model relies on a risk multiplier called the beta
coefficient, which we will discuss later in this lesson.
Like all financial models, the CAPM depends on certain assumptions. Originally
there were nine assumptions, although more recent work in financial theory has
relaxed these rules somewhat. The original assumptions were:

1. Investors are wealth maximizers who select investments based on expected

return and standard deviation.
2. Investors can borrow or lend unlimited amounts at a risk-free (or zero risk)
rate.

3. There are no restrictions on short sales (selling securities that you don't yet
own) of any financial asset.

4. All investors have the same expectations related to the market.

5. All financial assets are fully divisible (you can buy and sell as much or as
little as you like) and can be sold at any time at the market price.

6. There are no transaction costs.

7. There are no taxes.

8. No investor's activities can influence market prices.

9. The quantities of all financial assets are given and fixed.

OR

1. Aim to maximize economic utilities (Asset quantities are given and fixed).

2. Are rational and risk-averse.

3. Are broadly diversified across a range of investments.

4. Are price takers, i.e., they cannot influence prices.

5. Can lend and borrow unlimited amounts under the risk free rate of interest.

6. Trade without transaction or taxation costs.

7. Deal with securities that are all highly divisible into small parcels (All assets
are perfectly divisible and liquid).

8. Have homogeneous expectations.

9. Assume all information is available at the same time to all investors.

Obviously, some of these assumptions are not valid in the real world (most notably
no transaction costs or taxes), but CAPM still works well, and results can be
adjusted to overcome some of these assumptions.

The Beta Coefficient

Before we can use the CAPM formula, we need to understand its risk measurement
factor known as the beta coefficient. By definition, the securities market as a
whole has a beta coefficient of 1.0. The beta coefficients of individual companies
are calculated relative to the market's beta. A beta above 1.0 implies a higher risk
than the market average, and a beta below 1.0 implies less risk than the market
average. Most companies' betas fall between 0.75 and 1.50, but any number is
possible, including negative numbers; a negative beta would be highly
unlikely, however, since it would imply less risk than a 'risk free' investment.
For actual use, the beta coefficients of most companies can be found on financial
websites as well as in electronic publications. You can do a quick search to find
companies' beta coefficients.
Risk Averse
Share4
WHAT IT IS:

Risk averse is an oft-cited assumption in finance that an investor will always

choose the least risky alternative, all things being equal.

HOW IT WORKS (EXAMPLE):

Modern portfolio theory (MPT), which is the theory behind

why diversification works, relies on the assumption that investors are risk averse.

There is evidence to support the idea that investors are basically risk averse. People
buy insurance on valuable assets. People expect a higher yield on bonds that are
lower in priority when it comes to repayment. The assumption of risk aversion
leads to the conclusion that in order to entice someone to take a larger risk, he must
be compensated with a higher expected rate of return, or else he won't do it.

WHY IT MATTERS:

In finance and investing, it is almost universally recognized that the relationship

among all of the assets and liabilities in an investor's portfolio should be
considered in order to build an "optimum portfolio" for that investor's particular
level of risk -- and this phenomenon is called modern portfolio theory.

In other words, modern portfolio theory is the formula that explains both why and
how a portfolio should be diversified, and -- as mentioned above -- the assumption
that investors are risk averse is an underpinning of modern portfolio theory.

Capital Allocation Line CAL

What is the 'Capital Allocation Line - CAL'

The capital allocation line (CAL), also known as the capital market link (CML), is
a line created on a graph of all possible combinations of risk-free and risky assets.
The graph displays to investors the return they might possibly earn by assuming a
certain level of risk with their investment. The slope of the CAL is known as the
reward-to-variability ratio.

BREAKING DOWN 'Capital Allocation Line - CAL'

The CAL aids investors in choosing how much to invest in a risk-free asset and
one or more risky assets. Asset allocation is the allotment of funds across different
types of assets with varying expected risk and return levels, whereas capital
allocation is the allotment of funds between risk-free assets, such as certain
Treasury securities, and risky assets, such as equities.
Constructing Portfolios With the CAL

An easy way to adjust the risk level of a portfolio is to adjust the amount invested
in the risk-free asset. The entire set of investment opportunities includes every
single combination of risk-free and risky assets. These combinations are plotted on
a graph where the y-axis is expected return and the x-axis is the risk of the asset as
measured by standard deviation.

The simplest example is a portfolio containing two assets: a risk-free Treasury bill
and a stock. Assume that the expected return of the Treasury bill is 3% and its risk
is 0%. Further, assume that the expected return of the stock is 10% and its standard
deviation is 20%. The question that needs to be answered for any individual
investor is how much to invest in each of these assets. The expected return (ER) of
this portfolio is calculated as follows:

ER of portfolio = ER of risk-free asset x weight of risk-free asset + ER of risky

asset x (1- weight of risk-free asset)

The calculation of risk for this portfolio is simple because the standard deviation of
the Treasury bill is 0%. Thus, risk is calculated as:

Risk of portfolio = weight of risky asset x standard deviation of risky asset

In this example, if an investor were to invest 100% into the risk-free asset, the
expected return would be 3% and the risk of the portfolio would be 0%. Likewise,
investing 100% into the stock would give an investor an expected return of 10%
and a portfolio risk of 20%. If the investor allocated 25% to the risk-free asset and
75% to the risky asset, the portfolio expected return and risk calculations would be:

ER of portfolio = (3% x 25%) + (10% * 75%) = 0.75% + 7.5% = 8.25%

Risk of portfolio = 75% * 20% = 15%

Slope of the CAL

The slope of the CAL measures the trade-off between risk and return. A higher
slope means that investors receive higher expected return in exchange for taking on
more risk. The value of this calculation is known as the Sharpe ratio.

Capital Market Line CML

The capital market line (CML) appears in the capital asset pricing model to depict
the rates of return for efficient portfolios subject to the risk level (standard
deviation) for a market portfolio and the risk-free rate of return.

The capital market line is created by sketching a tangent line from the intercept
point on the efficient frontier to the place where the expected return on a holding
equals the risk-free rate of return. However, the CML is better than the efficient
frontier because it considers the infusion of a risk-free asset in the market portfolio.

BREAKING DOWN 'Capital Market Line - CML'

The capital asset pricing model (CAPM) proves that the market portfolio is the
efficient frontier. It is the intersection between returns from risk-free investments
and returns from the total market. The security market line (SML) represents this.

The capital asset pricing model determines the fair price of investments. Once
the fair value is determined, it is compared to the market price. A stock is a good
buy if the estimated price is higher than the market price. However, if the price is
lower than the market price, the stock is not a good buy.

In the CAPM, the securities are priced, so the expected risks counterbalance the
expected returns. There are two components needed to generate a CAPM, CML
and the SML. The capital market line conveys the return of an investor for a
portfolio. The capital market line assumes that all investors can own market
portfolios.

Single assets and nonefficient portfolios are not depicted on the CML.
Alternatively, the SML must be used. The capital market line permits the investor
to consider the risks of an additional asset in an existing portfolio. The line
graphically depicts the risk top investors earn for accepting added risk.

Separation Theorem

All investors have portfolios on the CML relying on the risk-return preferences.
However, the market portfolio and the CML are depicted without reference to
the risk-return tradeoff curves of the investors. This result is Tobins Separation
Theorem. It states that the best blend of risky assets in the market portfolio is
determined without considering the risk-return preferences of the investors.

Locating the best portfolio for a specific risk tolerance level consists of two
methods: finding the best blend of market securities that does not fluctuate
with risk tolerance and then joining it with a suitable amount of money.

History

In 1952, Harry Markowitz wrote his doctoral dissertation titled Portfolio Selection
that recognized the efficient frontier. In 1958, James Tobin included leverage to the
portfolio theory by including in the analysis an asset that pays a risk-free rate.
However, when combining a no-risk asset with a portfolio on the efficient frontier,
it is possible to assemble portfolios whose risk-return profiles are above those of
portfolios on the efficient frontier.

In 1964, William Sharpe developed the CAPM that exhibits assumptions; the
efficient portfolio has to be the market portfolio. Based on this, typical investors
must keep the market portfolio leveraged or deleveraged to realize their desired
risk.
Modern Portfolio Theory MPT

Modern portfolio theory (MPT) is a theory on how risk-averse investors can

construct portfolios to optimize or maximize expected return based on a given
level of market risk, emphasizing that risk is an inherent part of higher
reward.

According to the theory, it's possible to construct an "efficient frontier" of optimal

portfolios offering the maximum possible expected return for a given level of risk.

This theory was pioneered by Harry Markowitz in his paper "Portfolio Selection,"
published in 1952 by the Journal of Finance.

BREAKING DOWN 'Modern Portfolio Theory - MPT'

A major insight provided by MPT is that an investment's risk and return

characteristics should not be viewed alone, but should be evaluated by how the
investment affects the overall portfolio's risk and return.

MPT shows that an investor can construct a portfolio of multiple assets that will
maximize returns for a given level of risk. Likewise, given a desired level of
expected return, an investor can construct a portfolio with the lowest possible risk.
Based on statistical measures such as variance and correlation, an individual
investment's return is less important than how the investment behaves in the
context of the entire portfolio.

Portfolio Risk and Expected Return

MPT makes the assumption that investors are risk-averse, meaning they prefer a
less risky portfolio to a riskier one for a given level of return. This implies than an
investor will take on more risk only if he or she is expecting more reward.

The expected return of the portfolio is calculated as a weighted sum of the

individual assets' returns. If a portfolio contained four equally-weighted assets with
expected returns of 4, 6, 10 and 14%, the portfolio's expected return would be:

(4% x 25%) + (6% x 25%) + (10% x 25%) + (14% x 25%) = 8.5%

The portfolio's risk is a complicated function of the variances of each asset and the
correlations of each pair of assets. To calculate the risk of a four-asset portfolio, an
investor needs each of the four assets' variances and six correlation values, since
there are six possible two-asset combinations with four assets. Because of the asset
correlations, the total portfolio risk, or standard deviation, is lower than what
would be calculated by a weighted sum.

Efficient Frontier

Every possible combination of assets that exists can be plotted on a graph, with the
portfolio's risk on the X-axis and the expected return on the Y-axis. This plot
reveals the most desirable portfolios. For example, assume Portfolio A has an
expected return of 8.5% and a standard deviation of 8%, and that Portfolio B has
an expected return of 8.5% and a standard deviation of 9.5%. Portfolio A would be
deemed more "efficient" because it has the same expected return but a lower risk.
It is possible to draw an upward sloping hyperbola to connect all of the most
efficient portfolios, and this is known as the efficient frontier. Investing in any
portfolio not on this curve is not desirable.

Harry Markowitz was awarded a Nobel prize for developing MPT.