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Lesson 1 of 5 8–12% of the exam

The capital market line

If all investors share the same expectations, they all find the same optimal risky portfolio, so it must be the market portfolio of all risky assets. The capital allocation line through the market portfolio is the capital market line: E(Rp) = Rf + [(E(Rm) − Rf) ÷ σm] × σp.

6 min cram, 32 min full read. Based on the 2027 CFA® Program Level I curriculum, Portfolio Construction, Learning Module 2. Also part of the 2026 curriculum, so it applies to the November 2026 exam too.

Tailor this to you: take the self-assessment

Before this: The capital allocation line and the optimal portfolio

On the exam

  • Describe the implications of combining a risk-free asset with a portfolio of risky assets
  • Explain the capital allocation line (CAL) and the capital market line (CML)

Describe what combining the risk-free asset with a risky portfolio does, and explain the CAL and the CML. Expect a CML return or weight calculation, a leveraged portfolio with a higher borrowing rate, and a question on how the CML differs from a CAL.

How deeply to learn each part
Know the idea
Understand it in general. It frames other topics, but you will not calculate with it.
Use it
Understand it well enough to solve a question with it. Recognize when it applies.
Memorize
Learn it by heart. The exam will not give it to you.

You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.

You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.

Cram mode: the one-screen version of this lesson. Switch to Full for the explanations, worked examples and interactives.

What happens when you combine the risk-free asset with a risky portfolio?

The risk-free asset has zero variance and zero covariance with everything else, so it adds no risk of its own. Put a weight w in a risky portfolio and 1 − w in the risk-free asset, and both return and risk move in a straight line with w.

Return and risk of a mix with the risk-free asset Use it
E(Rp)=w E(Ri)+(1−w) Rf,σp=w σiE(R_p) = w\,E(R_i) + (1 - w)\,R_f, \qquad \sigma_p = w\,\sigma_i

A weight between 0 and 1 means part of your wealth is lent at the risk-free rate. A weight above 1 means you borrowed at the risk-free rate and invested more than your wealth. The line simply continues past the risky portfolio.

Each investor’s line depends on which risky portfolio they believe is best. That is the capital allocation line (CAL): one line per risky portfolio, and the best one is the steepest. So what happens when everyone agrees on which risky portfolio that is?

Why does everyone end up holding the market portfolio?

Suppose every investor uses the same inputs: the same expected returns, standard deviations and correlations. This is homogeneity of expectations . Everyone then draws the same efficient frontier, finds the same steepest line from the risk-free rate, and picks the same tangency portfolio. If every investor holds it, it must contain every risky asset in proportion to its market value. That is the market portfolio .

The capital market line (CML) is the CAL whose risky portfolio is the market portfolio. In practice a broad index stands in for “the market”, because no one can observe every risky asset.

Capital market line Memorize
E(Rp)=Rf+E(Rm)−Rfσm σpE(R_p) = R_f + \frac{E(R_m) - R_f}{\sigma_m}\,\sigma_p

The intercept is the risk-free rate and the slope is the extra return per unit of total risk, the market’s own Sharpe ratio.

Slope of the CML (market price of risk) Memorize
Slope=E(Rm)−Rfσm\text{Slope} = \frac{E(R_m) - R_f}{\sigma_m}

To land on a given risk level, hold the right share of the market. The rest sits in the risk-free asset (or is borrowed).

Weight in the market portfolio Use it
w=σpσmw = \frac{\sigma_p}{\sigma_m}
InteractiveThe capital market line: how much of the market do you hold?

Try this 0 of 3

  • Find the portfolio on the CML with a risk of exactly 12%
  • Borrow to hold 150% in the market, with the borrowing rate still at 2.5%
  • Keep 150% in the market and raise the borrowing rate to 4.5%
  • Efficient frontier of risky assets
  • CML
0%5%10%15%0%10%20%30%Risk, σ (%)Expected return (%)CMLRf 2.5%Market portfolio, M

The capital market line runs from the risk-free rate of 2.5% through the market portfolio (risk 16%, return 8.5%), slope 0.375. With 62.50% of wealth in the market the portfolio has risk 10.00% and expected return 6.25%.

CML slope (Sharpe ratio)0.375
In the risky portfolio62.5%
E(Rp)6.25%
σp10.00%
PositionLending 37.5% at Rf
Show working

CML slope = (8.50% − 2.50%) ÷ 16.00% = 0.375

E(Rp) = Rf + w × (E(R) − Rf) = 2.50% + 0.625 × (8.50% − 2.50%) = 6.25%

σp = w × σ = 0.625 × 16.00% = 10.00% (the risk-free asset adds no risk)

Weight from a target risk: w = σp ÷ σm = 10.00 ÷ 16 = 0.625.

Calculator. TI BA II Plus: 0.0850 [−] 0.0250 [=] [×] 0.625 [+] 0.0250 [=] gives 0.0625. HP 12C: 0.0850 [ENTER] 0.0250 [−] 0.625 [×] 0.0250 [+] gives 0.0625.

Everyone holds the market; how much decides where you sit on the line.

Slide the weight to move along the line and watch the readouts. Then raise the borrowing rate and see the line bend at the market portfolio. Everyone holds the market; how much of it decides where you sit.

Rearrange itCapital market line: solve for return, risk or the market return
The question asks for
The risk-free rate is 2.50%. The market portfolio has an expected return of 8.50% and a standard deviation of 16.00%. A portfolio on the capital market line with a standard deviation of 10.00% has an expected return closest to:

2.5 + (8.5 − 2.5) ÷ 16 × 10 = 6.25%

Portfolio expected return6.25%

On your calculator
  1. 8.5−2.5=÷16=×10+2.5=percent
  1. 8.5ENTER2.5−16÷10×2.5+percent

ENTER enter (on the HP, puts the number on the stack)

Where a portfolio sits on the capital market line
Weight in the market portfolio, w = σp ÷ σmthe rest is lent or borrowed at the risk-free rate
  • Lending portfolio Use it w between 0 and 1; part of wealth in the risk-free asset; more risk averse
  • The market portfolio Memorize w = 1; all wealth in risky assets
  • Borrowing (leveraged) portfolio Use it w above 1; borrow at the risk-free rate and invest more than all wealth in the market

Holding the market and adjusting only the lending or borrowing is a passive portfolio strategy: it lands on the CML. An active portfolio strategy departs from the market weights because the manager believes the market’s prices or forecasts are wrong. The names for the points on the line follow the weight: a lending portfolio has w below 1, a borrowing portfolio has w above 1, and a borrowing portfolio is also called a leveraged portfolio .

Passive and active strategies
Approaches to holding risky assetsthe CML describes the passive case
  • Passive Use it hold the market (an index fund), plus lending or borrowing
    • Lands on the CML the efficient set when everyone shares expectations
  • Active Use it overweight what you think is cheap, underweight what you think is dear
    • Bets that expectations differ from the market’s can land above or below the CML

What if borrowing costs more than lending?

Most investors cannot borrow at the risk-free rate. Suppose they lend at Rf but borrow at a higher rate Rb. To the left of the market portfolio nothing changes. To the right, the leveraged return is the market return on the whole position, less the cost of the borrowed part.

Leveraged portfolio with a borrowing rate above Rf Use it
E(Rp)=w E(Rm)−(w−1) Rb,w>1E(R_p) = w\,E(R_m) - (w - 1)\,R_b, \qquad w > 1

The line therefore has a kink at the market portfolio and is flatter beyond it. Its slope there is (E(Rm) − Rb) ÷ σm.

Rearrange itBorrowing above the risk-free rate: solve for any input
The question asks for
An investor puts 150% of wealth in the market portfolio, which is expected to return 8.50%, and borrows the excess at 4.50%. The expected return on the investor's wealth is closest to:

1.5 × 8.5 − 0.5 × 4.5 = 10.50%

Portfolio expected return10.50%

On your calculator
  1. 1.5×8.5−(0.5×4.5)=percent
  1. 1.5ENTER8.5×0.5ENTER4.5×−percent

ENTER enter (on the HP, puts the number on the stack)

Go deeper Why the market portfolio should hold everything

The theoretical market portfolio holds every risky asset, not only listed shares: bonds, real estate, even human capital. Nobody can observe all of that, so analysts use a broad index as a proxy. Different proxies give different CMLs, which is one reason the model is hard to test.

The CML’s slope is the best Sharpe ratio available from combining the risk-free asset with risky assets. No other risky portfolio has a steeper line from Rf.

In practice, limits on short selling and on margin borrowing also stop investors from reaching every point on the line.

Exam tip Weight first: w = σp ÷ σm. Then E = Rf + w × (E(Rm) − Rf). If w is above 1, check whether the question gives a borrowing rate.

Memorize this

MemorizeThe capital market line

Memory hook It is the CAL from the last module with one change: the risky portfolio is the market. Intercept Rf, slope the market’s Sharpe ratio, x-axis total risk.

Know it cold E(Rp)=Rf+E(Rm)−Rfσm σpE(R_p) = R_f + \dfrac{E(R_m) - R_f}{\sigma_m}\,\sigma_p; weight in the market w=σp÷σmw = \sigma_p \div \sigma_m.

MemorizeCAL versus CML

CALCML
Risky portfolioany one; an investor’s own optimal portfoliothe market portfolio
Expectationscan differ across investorshomogeneous (shared)
Risk on the x-axisσ (total risk)σ (total risk)
SlopeSharpe ratio of that risky portfolioSharpe ratio of the market

Memory hook The CML is a special CAL. Same axes, only the risky portfolio is pinned down.

MemorizeDifferent borrowing and lending rates

Memory hook Borrowing costs more, so each extra unit of leverage earns less.

Know it cold Lend at RfR_f, borrow at Rb>RfR_b > R_f: the line bends at M and is flatter to the right. Leveraged return =wE(Rm)−(w−1)Rb= wE(R_m) - (w-1)R_b.

Where a portfolio sits on the capital market line
Weight in the market portfolio, w = σp ÷ σmthe rest is lent or borrowed at the risk-free rate
  • Lending portfolio Use it w between 0 and 1; part of wealth in the risk-free asset; more risk averse
  • The market portfolio Memorize w = 1; all wealth in risky assets
  • Borrowing (leveraged) portfolio Use it w above 1; borrow at the risk-free rate and invest more than all wealth in the market
Passive and active strategies
Approaches to holding risky assetsthe CML describes the passive case
  • Passive Use it hold the market (an index fund), plus lending or borrowing
    • Lands on the CML the efficient set when everyone shares expectations
  • Active Use it overweight what you think is cheap, underweight what you think is dear
    • Bets that expectations differ from the market’s can land above or below the CML
Return and risk of a mix with the risk-free asset Use it
E(Rp)=w E(Ri)+(1−w) Rf,σp=w σiE(R_p) = w\,E(R_i) + (1 - w)\,R_f, \qquad \sigma_p = w\,\sigma_i
Quick example

75% in a risky portfolio expected to earn 8.5% with σ = 16%, 25% in a bill paying 2.5%. E = 0.75 × 8.5 + 0.25 × 2.5 = 7.0%; σp = 0.75 × 16 = 12%.

On your calculator
  1. 0.75×8.5+(0.25×2.5)= 7
  1. 0.75ENTER8.5×0.25ENTER2.5×+ 7

ENTER enter (on the HP, puts the number on the stack)

Capital market line Memorize
E(Rp)=Rf+E(Rm)−Rfσm σpE(R_p) = R_f + \frac{E(R_m) - R_f}{\sigma_m}\,\sigma_p
Quick example

Rf = 4%, E(Rm) = 10%, σm = 20%. A portfolio with σp = 15% expects 4 + (6 ÷ 20) × 15 = 8.5%.

On your calculator
  1. 10−4=÷20=×15+4= 8.5
  1. 10ENTER4−20÷15×4+ 8.5

ENTER enter (on the HP, puts the number on the stack)

Slope of the CML (market price of risk) Memorize
Slope=E(Rm)−Rfσm\text{Slope} = \frac{E(R_m) - R_f}{\sigma_m}
Quick example

Rf = 4%, E(Rm) = 10%, σm = 20%. (10 − 4) ÷ 20 = 0.30: 0.30 points of extra return per point of risk, the market’s Sharpe ratio.

On your calculator
  1. 10−4=÷20= 0.3
  1. 10ENTER4−20÷ 0.3

ENTER enter (on the HP, puts the number on the stack)

Weight in the market portfolio Use it
w=σpσmw = \frac{\sigma_p}{\sigma_m}
Quick example

σm = 20% and a target σp of 25% need w = 25 ÷ 20 = 1.25: 125% in the market, 25% borrowed.

On your calculator
  1. 25÷20= 1.25
  1. 25ENTER20÷ 1.25

ENTER enter (on the HP, puts the number on the stack)

Leveraged portfolio with a borrowing rate above Rf Use it
E(Rp)=w E(Rm)−(w−1) Rb,w>1E(R_p) = w\,E(R_m) - (w - 1)\,R_b, \qquad w > 1
Quick example

Rf = 4%, borrowing rate 6%, E(Rm) = 10%, w = 1.25. E = 1.25 × 10 − 0.25 × 6 = 11.0%, against 11.5% if borrowing were at Rf.

On your calculator
  1. 1.25×10−(0.25×6)= 11
  1. 1.25ENTER10×0.25ENTER6×− 11

ENTER enter (on the HP, puts the number on the stack)

How it is asked

  1. Return at a target risk

    Rf 2%, E(Rm) 10%, σm 20%. Expected return of a CML portfolio with σp = 14%?

    w = 14 ÷ 20 = 0.7, so E = 2 + 0.7 × 8 = 7.60%. Trap: 7.00% (0.7 × 10, forgets the cash).

  2. Leveraged position

    Target σp above the market’s σ. What does the investor do?

    w = σp ÷ σm above 1: borrow at Rf and hold more than 100% in the market.

  3. Higher borrowing rate

    Same market, but borrowing costs more than Rf. What happens to the line?

    Beyond M the line is flatter; use E = wE(Rm) − (w − 1)Rb. Trap: using Rf for the borrowing.

  4. CML versus another line

    Which line measures risk with beta?

    The security market line (SML), not the CML. The CML uses standard deviation and covers efficient portfolios only.

Exam traps

  • Mixing up the CML and the SML. The CML has standard deviation on the x-axis and holds only efficient portfolios; the SML has beta on the x-axis and holds every asset.
  • Giving the risk-free asset a share of the portfolio's risk. It has zero standard deviation and zero covariance, so σp = w × σm.
  • Using Rf as the borrowing rate when the question gives a higher one. The leveraged return is w × E(Rm) − (w − 1) × Rb.
  • Forgetting the cash in a lending portfolio. A 60% weight in the market leaves 40% earning Rf, so E is not 0.6 × E(Rm).

Checkpoint

4 exam-style questions. About 90 seconds each.

  1. 1The risk-free rate is 3%, the market's expected return is 9% and its standard deviation is 15%. A portfolio on the capital market line with a standard deviation of 9% has an expected return closest to:

  2. 2The capital market line differs from a general capital allocation line in that the CML:

  3. 3If investors can borrow only at a rate above the risk-free rate, the capital market line to the right of the market portfolio becomes:

  4. 4The risk-free rate is 3%, the market's expected return is 9% and its standard deviation is 15%. An investor can lend at 3% but must borrow at 5%, and wants a portfolio with a standard deviation of 18%. The expected return is closest to:

Key takeaways

  • Combining the risk-free asset with a risky portfolio gives a straight line in risk and return.
  • Same expectations lead to the same tangency portfolio, which must be the market portfolio, so the line is the CML.
  • CML: E(Rp) = Rf + [(E(Rm) − Rf) ÷ σm] × σp, with slope equal to the market's Sharpe ratio.
  • A borrowing rate above Rf bends the line flatter beyond the market portfolio.
Return and risk of a mix with the risk-free asset Use it
E(Rp)=w E(Ri)+(1−w) Rf,σp=w σiE(R_p) = w\,E(R_i) + (1 - w)\,R_f, \qquad \sigma_p = w\,\sigma_i
Quick example

75% in a risky portfolio expected to earn 8.5% with σ = 16%, 25% in a bill paying 2.5%. E = 0.75 × 8.5 + 0.25 × 2.5 = 7.0%; σp = 0.75 × 16 = 12%.

On your calculator
  1. 0.75×8.5+(0.25×2.5)= 7
  1. 0.75ENTER8.5×0.25ENTER2.5×+ 7

ENTER enter (on the HP, puts the number on the stack)

Capital market line Memorize
E(Rp)=Rf+E(Rm)−Rfσm σpE(R_p) = R_f + \frac{E(R_m) - R_f}{\sigma_m}\,\sigma_p
Quick example

Rf = 4%, E(Rm) = 10%, σm = 20%. A portfolio with σp = 15% expects 4 + (6 ÷ 20) × 15 = 8.5%.

On your calculator
  1. 10−4=÷20=×15+4= 8.5
  1. 10ENTER4−20÷15×4+ 8.5

ENTER enter (on the HP, puts the number on the stack)

Slope of the CML (market price of risk) Memorize
Slope=E(Rm)−Rfσm\text{Slope} = \frac{E(R_m) - R_f}{\sigma_m}
Quick example

Rf = 4%, E(Rm) = 10%, σm = 20%. (10 − 4) ÷ 20 = 0.30: 0.30 points of extra return per point of risk, the market’s Sharpe ratio.

On your calculator
  1. 10−4=÷20= 0.3
  1. 10ENTER4−20÷ 0.3

ENTER enter (on the HP, puts the number on the stack)

Weight in the market portfolio Use it
w=σpσmw = \frac{\sigma_p}{\sigma_m}
Quick example

σm = 20% and a target σp of 25% need w = 25 ÷ 20 = 1.25: 125% in the market, 25% borrowed.

On your calculator
  1. 25÷20= 1.25
  1. 25ENTER20÷ 1.25

ENTER enter (on the HP, puts the number on the stack)

Leveraged portfolio with a borrowing rate above Rf Use it
E(Rp)=w E(Rm)−(w−1) Rb,w>1E(R_p) = w\,E(R_m) - (w - 1)\,R_b, \qquad w > 1
Quick example

Rf = 4%, borrowing rate 6%, E(Rm) = 10%, w = 1.25. E = 1.25 × 10 − 0.25 × 6 = 11.0%, against 11.5% if borrowing were at Rf.

On your calculator
  1. 1.25×10−(0.25×6)= 11
  1. 1.25ENTER10×0.25ENTER6×− 11

ENTER enter (on the HP, puts the number on the stack)

All Portfolio Construction formulas, every lesson

Practice exam-style questions on Portfolio Risk and Return: Part II (CAPM and Performance Measures)

Questions about this lesson?

Where this comes back

Questions candidates ask

What is the difference between the CAL and the CML?

A capital allocation line joins the risk-free asset with any risky portfolio, so each investor can have their own. The capital market line is the one whose risky portfolio is the market portfolio, which is what every investor holds when expectations are shared. Both plot expected return against standard deviation.

Why is the market portfolio the optimal risky portfolio?

With the same inputs, every investor finds the same steepest line from the risk-free rate to the efficient frontier, so everyone chooses the same risky portfolio. If everyone holds it, it must contain every risky asset in proportion to its market value. That is the market portfolio.

What happens to the CML when the borrowing rate is higher than the lending rate?

The line has a kink at the market portfolio. To the left, lenders still earn the risk-free rate. To the right, borrowers pay the higher rate, so each extra unit of risk adds less return and the line is flatter.

Spotted an error? Tell us and we will fix it.

  1. The capital market line
  2. Systematic vs nonsystematic risk and return-generating models
  3. How to calculate and interpret beta
  4. The CAPM and the security market line
  5. Sharpe ratio, Treynor ratio, M² and Jensen's alpha

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