Free Investment Banking Course. Login details for this Free course will be emailed to you. Forgot Password? Article by Madhuri Thakur. The efficient frontier Efficient Frontier The efficient frontier, also known as the portfolio frontier, is a collection of ideal or optimal portfolios that are expected to provide the highest return for the minimum level of risk.
This frontier is formed by plotting the expected return on the y-axis and the standard deviation on the x-axis. If we draw a line from the risk-free rate of return, which is tangential to the efficient frontier, we get the Capital Market Line.
The point of tangency is the most efficient portfolio. Moving up the CML will increase the risk of the portfolio, and moving down will decrease the risk. Subsequently, the return expectation Return Expectation The Expected Return formula is determined by applying all the Investments portfolio weights with their respective returns and doing the total of results.
Leave a Reply Cancel reply Your email address will not be published. Please select the batch. Cookies help us provide, protect and improve our products and services. Difference Between Similar Terms and Objects. MLA 8 S, Prabhat. As fas as I known from my professor in University, Characteristic Line is the line of relation between single asset risk and the market risk, but SML is the line of relation between many assets risk market portfolio and the market risk.
In SML, only risk measure taken along x axis is Beta. It is measured as covariance of an asset to variance of market variance. So characteristic line explains risk of an asset and risk of a market. Therefore, SML and characteristic line are same. They are the same thing. The professor at my university said that Characteristic line is just another word for Security Market line.
My professor had taught me that characteristic line is a regration line that shows relationship between return from stock and return from market. Another basis difference is that CMLis the basis of the capital market theory and SML is the basis of the capital asset pricing model. Name required. They are the best performing portfolios. Risk is represented by using a standard deviation on the x-axis, while the y-axis represents the expected return of a portfolio.
It consists of a mix of risk-free assets and risky assets. They offer an optimal risk-return trade-off i. The capital market line assumes the risk portfolio as a market portfolio. Graphically, a line is drawn that connects the market portfolio with the risk-free asset. This line is the capital market line. Portfolio risk and the return an investor expects are proportional to each other. The higher the investor climbs up the capital market line, the greater the portfolio risk and the expected return, and vice versa.
Let us understand the above equation using an example. Therefore, we see that with the increase along the capital market line, or with the increase in risk as measured by the standard deviation, the expected returns also increase, and vice versa.
Expected returns decrease as the risk or standard deviation decreases. As described above, CML assumes that the entire risk portfolio is the market portfolio. The measure of the return of a financial portfolio that is adjusted to the risk is Sharpe Ratio. Therefore, a higher Sharpe Ratio means a better portfolio and vice versa.
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