Unformatted text preview: eturn. It is a measure of the reward for holding the risky market
portfolio rather than the riskfree asset. The denominator is the market risk
of the market portfolio. Thus, the first factor, or the slope of the CML,
measures the reward per unit of market risk. Since the CML represents the
return offered to compensate for a perceived level of risk, each point on the
CML is a balanced market condition, or equilibrium. The slope of the CML RISK AND PORTFOLIO MANAGEMENT WITH ECONOMETRICS, VER. 10/23/2012. © P. KOLM. 28 determines the additional return needed to compensate for a unit change in
risk, which is why it is also referred to as the equilibrium market price of
risk. In other words, the CML says that the expected return on a portfolio is
equal to the riskfree rate plus a risk premium, where the risk premium is
equal to the market price of risk (as measured by the reward per unit of
market risk) times the quantity of risk for the portfolio (as measured by the
standard deviation of the portfolio) RISK AND PORTFOLIO MANAGEMENT WITH ECONOMETRICS, VER. 10/23/2012. © P. KOLM. 29 Practical implications Portfolio construction is normally broken down into at least the following two
steps:
1. Asset allocation: decide how to allocate the investor’s wealth between the
riskfree security and the set of risky securities...
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 Fall '14
 CML, Modern portfolio theory, P. KOLM

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