become attractive once again and the analysts would have to recommend its inclusion in
the portfolio M. hence we may say that portfolio M will be a portfolio from which none
of the risky securities from the market may be left out.
Again, if a particular security J were considered particularly attractive so that the analysts
recommended a large proportion of investors’ capital to be invested in J, everybody who
does not already have that proportion of J in his portfolio would rush to buy more of J till
the price of J rose to a level where its return would no longer appear attractive and one
would be forced to reduce the proportion of holding in J. Hence we may say that in
equilibrium, portfolio M would not only comprise every risky security in the market, but
the proportion of investment in each security will be proportional to the market
capitalization of that security – no more, no less (market capitalization of a security is its
market price multiplied by the number of that security outstanding in the market). It can
be readily seen that the entire market taken as a whole is indeed one such portfolio!
Capital Market Line
Thus the portfolio M is nothing but the market portfolio that is a portfolio comprising all
the risky securities that are traded in the market. As we have already seen, since the
efficient frontier is a straight line passing through F and M, all investors would have their
portfolios on this line. This line is called the capital market line (CML) (Fig. 5). The
relationship between the return and risk of any portfolio, P, on this line is given by the
following equation:
Risk premium of a portfolio =Fisk premium of market X Risk of Portfolio
Risk of Market
Where
Risk premium of a portfolio is the excess of the expected portfolio return (Ep)
over the risk-free rate of return,
Risk premium of market is the excess of the expected market return (Em) over the
risk-free rate of return, and
Risk of portfolio and market refer respectively to the s’s of the portfolio and
market returns.
The above equation implies that CML passes through the risk-free rate, rf, which
represents the pure time value of money, or, the reward for waiting.
Security Market Line
The Modern Portfolio Theory (MPT), as we have seen, argues that investors dislike risk,
and, therefore, will buy a riskier security only if they are suitably rewarded in the form of
higher expected return. This suggests that in a well-functioning market in which
securities are correctly priced there should be a relationship between return and risk of