Capital market line (CML):

The next step in deriving capital asset pricing model is to

define a set of criteria for identifying preferred
investments. Probably the most straight forward method
is the mean-variance criteria. It utilizes only the mean
and variance of expected returns to identify the
investment that dominate. And Investment A Dominates
Investment B if Investor always prefer A to B. The Mean
Variance criteria assumes that continously compounded
return around the mean is standard deviation. Using the
mean as the measure of expected return and standard
deviation as the measure of risk, we can represent
any investment in this risk return space as a single
point. An examples of Investment A with expected return
and standard deviation.
By plotting the dominant investment in risk return space,
we can identify the set of investment that are not
dominated by any other investment. This is the meanvariance efficient set or efficient frontier of portfolios of
risky assets. The point of tangency between the efficient
frontier and the highest possible indifference curve of an
investment will identified the investor preferred portfolio.
Production of risk free assets with borrowing at the
risk free rate leads to capital market line. The CML is
the linear relationship between expected return
and total risk. Its become the new efficient frontier. The
point of tangency between the CML and the old efficient
frontier is risky assets identified the market portfolio. The

market portfolio id perfectly diversified mean-variance

efficient portfolio containing every investment in
quantity proportional to there total market value. The
tangency between the highest indifference curve and the
CML reveals the investors preferred portfolio mix.
The preferred portfolio is L on the indifference curve
U3. For this investor portfolio L would be the investment
alternative that maximizes expected return within the
investors risk contraints and yield the highest possible
utility.
The empirical tests show that the CAPM is a fairly good
representation on the market but there seem to be
significant deviations of empirical results from the theory
and conclusions of many studies are often conflicting.
Therefore, several alternative have developed to this
model.
The Capital Assets Pricing Model gives a relationship
between a securities risk and return. The excess of return
earned on any other securities is the risk premium or the
reward for the excess risk pertaining to that security.
According to CAPM , the required rate of return on
security is equal to risk free rate + ( beta of security x
Market risk premium ). The market Risk premium is the
difference between average Rate of return on Market and
the BSE free Rate. The average Rate of Return on a
Market index like the BSE National Index can be taken as
Proxy for the average rate of return on the market.