Figure 6.3

Capital Market Line

You have seen that the presence of a risk-free asset lets you attain better risk/return points than when there is no risk-free asset. When there is no risk-free asset, the investment opportunity set is the straight line in Figure 6.3 going from rf through M, the point of tangency to the bullet-shaped graph.

The slope of this line is a function of the excess return provided by the portfolio M over the risk-free rate and equals:

The line that has the steepest possible slope, given the minimum-variance frontier, is called the capital market line (CML). An important implication of the CML is that the risk/return trade-off in the market is linear; if you increase your target return, the extra risk you have to undertake increases linearly.

The calculation of the CML is presented in topic 6.7, entitled Three-Firm Case: CML.

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