Financial Risk Manager Part 1

Explanation

The correct answer is D. The capital market line.

What is the Capital Market Line (CML)?

The CML is a line that illustrates the trade-off between expected return and standard deviation (risk) for efficient portfolios. It is derived from the Modern Portfolio Theory and is an important concept in financial investment.

Key Characteristics of CML:

• Starts from the risk-free rate on the vertical axis (where standard deviation = 0)
• Extends to the optimal risky portfolio (the tangency portfolio on the efficient frontier)
• Shows the relationship between risk (as measured by standard deviation) and return of efficient (market) portfolios
• Appears as a tangent from the intercept point on the efficient frontier to the point where the risk-free rate of return equals the expected return
• Slope represents the market price of risk - the additional expected return per unit of standard deviation that an investor can expect to earn by moving from a risk-free investment to a risky one

Why Other Options Are Incorrect:

A. The efficient frontier - This is not a line but a set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. It does not originate from the point representing the risk-free rate.

B. The characteristic line - This is used in the Capital Asset Pricing Model (CAPM) to depict the systematic risk of an individual security as its correlation with market returns, and it's not related to visualizing the relationship between overall portfolio risk and return.

C. The indifference curve - This represents combinations of risk and return that an investor views as equally preferable, which doesn't necessarily extend from the point representing the risk-free rate to optimal risky portfolio.

Practical Application:

The CML is used by investors to choose their optimal portfolio, given their level of risk tolerance. Investors can combine the risk-free asset with the market portfolio to achieve any point along the CML that matches their risk preferences.