Capital Market Theory | CFA Level I Portfolio Management

Welcome back as we continue our discussion on portfolio risk and return. Today, we’ll dive into capital market theory and explore the special case of the capital allocation line known as the capital market line.

Quick Recap of Key Concepts

• Efficient frontier of risky assets is formed from the expected risk and returns of all investable risky assets.
• Capital allocation line (CAL) is optimal when tangential to the efficient frontier.
• Optimal risky portfolio sits at the intersection of the CAL and the efficient frontier.
• Investor’s optimal portfolio is found when combined with their indifference curve.
• Expected return of the portfolio is the weighted average of the risk-free rate and the risky rate of return.
• Standard deviation of returns is the weight of the risky portfolio multiplied by its standard deviation.

Capital Market Theory and the Capital Market Line

Under the simplifying assumption that investors have homogeneous expectations, all investors face the same efficient frontier and have the same optimal capital allocation line, termed the capital market line (CML).

This also means that every investor will use the same optimal risky portfolio, which is the market portfolio of all risky assets. The CFA curriculum typically uses a local or regional stock market index as the market’s proxy.

Investor Portfolio Choices and the Capital Market Line

Investors with different risk preferences may choose various combinations of the risk-free asset and the market portfolio:

• More risk-averse investors allocate a greater proportion to risk-free assets.
• Less risk-averse investors allocate more or even borrow to invest in the market.

The expected portfolio return is equal to the risk-free rate, plus the market returns over the risk-free rate, multiplied by the factor of portfolio risk to market risk. The difference between the expected return on the market and the risk-free rate is termed the market risk premium.

Investors can expect one unit of market risk premium for every unit of market risk they’re willing to accept.

Borrowing and Lending Portfolios

• Borrowing portfolios are to the right of the market portfolio, where investors borrow to get leveraged returns.
• Lending portfolios are to the left, where investors allocate at least partially to risk-free assets.

Passive vs. Active Portfolios

Investors may choose between passive and active investment strategies:

• Passive investment strategy: Investors invest in a broad market equity fund that serves as a proxy for the market portfolio and allocate spare cash to risk-free assets.
• Active portfolio management: Investors invest more in undervalued securities and less in overvalued ones, aiming to obtain higher risk-adjusted returns relative to the market.

And that wraps up our lesson on capital market theory. In the next lesson, we’ll explore systematic and unsystematic risk.