Definition
The CML extends the efficient frontier by allowing borrowing and lending at the risk-free rate. The tangent portfolio (where CML touches the efficient frontier) is the optimal risky portfolio—according to CAPM, this is the market portfolio. All rational investors hold a mix of the risk-free asset and the tangent portfolio, choosing their position on the CML based on risk tolerance.
functions Formula
E(Rc) = Rf + [(E(Rm) − Rf) / σm] × σc
lightbulb Example
Risk-free rate 4%, market return 10%, market vol 15%. CML slope = (10%-4%)/15% = 0.40. A portfolio with 12% vol has expected return = 4% + 0.40 × 12% = 8.8%.
verified_user Key Points
- Extends efficient frontier with risk-free lending/borrowing
- Tangent portfolio is the optimal risky portfolio
- All investors hold combinations of risk-free and tangent portfolio
- Slope = Sharpe ratio of the market portfolio