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Answer: The capital market line always has a positive slope and its steepness depends on the market risk premium and the volatility of the market portfolio.
The correct answer is A. The capital market line (CML) is a graphical representation that connects the risk-free asset with the market portfolio, which is the most efficient portfolio of risky assets. The slope of the CML is determined by the market risk premium, which is the difference between the expected return on the market portfolio (RM) and the risk-free rate (Rp), and the volatility of the market portfolio, represented by the standard deviation of the market portfolio (σM). The equation of the CML is given by: \[ Re = Rp + \frac{(RM - Rp)}{\sigma_M} \] where \( Re \) is the expected return on an efficient portfolio. The slope of the CML, \( \frac{(RM - Rp)}{\sigma_M} \), is positive because the market risk premium is positive, and it increases as the market risk premium increases or the market volatility decreases. Option B is incorrect because the CML connects the risk-free asset with the market portfolio, not the zero-beta minimum-variance portfolio. Option C is incorrect because the portfolio with the lowest standard deviation on the efficient frontier is the risk-free asset, not a portfolio of risky assets. Investors with low risk tolerance would allocate most of their funds to the risk-free asset. Option D is incorrect because the CAPM assumes that all market participants have homogeneous expectations and therefore the same forecasts for asset returns. As a result, all investors hold the market portfolio, which is the same for everyone.
Author: LeetQuiz Editorial Team
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During a seminar on modern portfolio theory, which is a framework for constructing a portfolio of assets that maximizes expected return for a given level of risk, two risk analysts are present. The seminar includes a detailed presentation on key concepts such as the efficient frontier (which represents the set of optimal portfolios offering the highest expected return for a defined level of risk), the capital market line (CML, which depicts the risk-reward profile of efficient portfolios in the market considering a risk-free asset), and the Capital Asset Pricing Model (CAPM, which describes the relationship between systematic risk and expected return for assets). Based on the assumption that the CAPM holds true, which of the following statements can the analysts accurately conclude?
A
The capital market line always has a positive slope and its steepness depends on the market risk premium and the volatility of the market portfolio.
B
The capital market line is the straight line connecting the risk-free asset with the zero-beta minimum-variance portfolio.
C
The portfolio of risky assets with the lowest standard deviation on the efficient frontier is typically held by the least risk averse investors.
D
The efficient frontier indicates that different individuals hold different portfolios of risky assets based upon their individual forecasts for asset returns.