Thus, the CML becomes the new efficient frontier. Now, the line R f-M dominates all portfolios on the original efficient frontier. This means they are borrowing funds to buy more of portfolio M. To the right of M, investors hold more than 100% of portfolio M.This means investors are lending some of their funds (buying the risk-free asset). Between R f and M investors hold both the risk-free asset and portfolio M.Investors at point M have 100% of their funds invested in portfolio M.Investors at point R f have 100% of their funds invested in the risk-free asset.Note: When p (a,b) = 1 then the equation for risk changes to σ portfolio = W Aσ A + W Bσ B. Since the line is straight, the math implies that any two assets falling on this line will be perfectly positively correlated with each other.

This straight efficient frontier line is called the Capital Market Line (CML) for all investors, and Capital Allocation Line (CAL) for one investor. The introduction of a risk-free asset changes the efficient frontier into a straight line. The R fM line dominates everything else in terms of return offered for the level of risk taken.

At point M you reach the best combination.

You can keep getting better portfolios by moving up the efficient frontier.

Why? Because you always get more return for a given amount of risk. But any combination on the line R fB will dominate R fA. Observe that any combination on the line R fA dominates the portfolios below it. Remember, the combination of the risk-free asset and portfolio A will be a straight line.

Now combine the risk-free asset with portfolio A.

Hint: start with one that is already on the efficient frontier since you know that these portfolios dominate everything below them in terms of return offered for risk taken.

First, pick a risky stock or risky portfolio A.

The standard deviation of the new portfolio is the linear proportion of the standard deviation of the risky asset portfolio T: σ portfolio = w T σ TĪ graph of possible portfolio risks-return combinations becomes a straight line between the two assets.

The expected rate of return for the new portfolio is the weighted average of the two returns: E(R) = (1 - w T) R f + w T E(R T).

When a risk-free asset is combined with a risky portfolio (assume the proportion of the portfolio the investor places in the tangency portfolio T is w T): The risk free asset is important to the capital asset pricing model.

Therefore, a risk-free asset lies on the vertical axis of a portfolio graph. That is, a risk-free asset's expected return is entirely certain, and is known as the risk-free rate of return (RFR).

zero variance) around the expected return. However, investors may choose to invest in a risk free asset, which is assumed to have an expected return commensurate with an asset that has no standard deviation (i.e. The efficient frontier only considers the investments in risky assets.

Cml investment