There are no friction to impede investing, security market is an perfect market. This is imply that all investor, in equilibrium, would obtain the same tangency portfolio which is the optimal one, because investors have same expected return, standard deviation and covariance . Also, the linear efficient set is the same for all investors. Since all investor face the same efficient set, the only reason they will select different portfolio is the difference curves are different. Although the chosen portfolio is different ,nevertheless the chosen combination of risky securities have same relative proportions. This feature is known as separation theorem. (1. Sharpe ).
Another feature of CAPM is that in equilibrium each security must have a nonzero proportion in the composition of the tangency portfolio. In equilibrium, the proportions of tangency portfolio will correspond to the proportions of what is known as the market portfolio, defined as : A portfolio consisting of an investment in all securities. The proportion invested in each security equals to the percentage of the total market capitalization represented by security. (1)( sharp 230&920 ) .
E( R ).
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E( Rm ) M.
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Figure 1 .
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The market portfolio plays a important role in the CAPM because the efficient set consists of risk free borrowing/lending and the investment in the market portfolio. As can be seen from the Figure 1, the tangency portfolio M is denoted as the market portfolio, and R represents the risk free rate of return. Therefore, the efficient set consists of a single straight line , emanating from the risk free point R and passing through the market portfolio M. This line RM is called capital market line ( CML ). Since the slope of CML equal to the difference between the expected return of the market portfolio and that of riskfree security ( E( Rm )-R ) divided by the difference in their risks , and the vertical intercept of CML is R, In mathematical terms the CML can be written as :.
