Capital Allocation Line (CAL)

What Is the Capital Allocation Line (CAL)?

The capital allocation line (CAL), otherwise called the capital market connect (CML), is a line made on a graph of all potential combinations of risk-free and risky assets. The graph shows the return investors could earn by expecting a certain level of risk with their investment. The slant of the CAL is known as the award to-changeability ratio.

Understanding the Capital Allocation Line (CAL)

The capital allocation line helps investors in picking the amount to invest in a risk-free asset and at least one risky assets. Asset allocation is the allotment of funds across various types of assets with fluctuating expected risk and return levels, though capital allocation is the allotment of funds between risk-free assets, like certain Treasury securities, and risky assets, for example, equities.

Building Portfolios With the CAL

A simple method for changing the risk level of a portfolio is to change the amount invested in the risk-free asset. The whole set of investment opportunities incorporates each and every combination of risk-free and risky assets. These combinations are plotted on a graph where the y-hub is the expected return and the x-pivot is the risk of the asset as estimated by the standard deviation.

The simplest model is a portfolio containing two assets: a risk-free Treasury bill and a stock. Accept that the expected return of the Treasury bill is 3% and its risk is 0%. Further, accept that the expected return of the stock is 10% and its standard deviation is 20%. The inquiry that should be responded to for any individual investor is the amount to invest in every one of these assets. The expected return (ER) of this portfolio is calculated as follows:

Emergency room of portfolio = ER of risk-free asset x weight of risk-free asset + ER of risky asset x (1-weight of risk-free asset)

The calculation of risk for this portfolio is simple on the grounds that the standard deviation of the Treasury bill is 0%. Along these lines, risk is calculated as:

Risk of portfolio = weight of risky asset x standard deviation of risky asset

In this model, assuming an investor were to invest 100% into the risk-free asset, the expected return would be 3% and the risk of the portfolio would be 0%. Moreover, investing 100% into the stock would provide an investor with an expected return of 10% and a portfolio risk of 20%. Assuming that the investor allocated 25% to the risk-free asset and 75% to the risky asset, the portfolio expected return and risk calculations would be:

Trama center of portfolio = (3% x 25%) + (10% * 75%) = 0.75% + 7.5% = 8.25%

Risk of portfolio = 75% * 20% = 15%

The Slope of the CAL

The slant of the CAL measures the compromise among risk and return. A higher slant means that investors receive a higher expected return in exchange for facing more risk. The value of this calculation is known as the Sharpe ratio.