Capital allocation line

Capital allocation line (CAL) is a graph created by investors to measure the risk of risky and risk-free assets.

The graph displays the return to be made by taking on a certain level of risk.

Hence, the slope of the capital allocation line is called the reward-to-variability ratio because the expected return increases continually with the increase of risk as measured by the standard deviation.

By rearranging, we can see the risk premium has the following value Now consider the case of another portfolio that is a combination of a risk free asset and the correctly priced portfolio we considered above (which is itself just another risky asset).

If it is correctly priced, it will have exactly the same form: Substituting in our derivation for the risk premium above: This yields the Capital Allocation Line.

An example capital allocation line. As illustrated by the article, the slope dictates the amount of return that comes with a certain level of risk.