Financial Risk Manager Part 1
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The difference between the capital market line (CML) and the efficient frontier (EF) is that:
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TTanishq
A
The CML represents possible combinations of portfolios consisting of all possible proportions between the market portfolio and a risk-free asset while the EF represents all possible combinations of efficient portfolios, taking into account only risky assets in varying proportions.
B
The EF represents possible combinations of portfolios consisting of all possible proportions between the market portfolio and a risk-free asset while the CML represents all possible combinations of efficient portfolios, taking into account only risky assets in varying proportions.
C
The CML represents a few possible combinations of portfolios consisting of various proportions between the market portfolio and a risk-free asset while the EF represents all possible combinations of efficient portfolios, taking into account only risk-free assets in varying proportions.
D
The EF represents possible combinations of portfolios consisting of all possible proportions between the market portfolio and a risk-free asset while the CML represents all possible combinations of efficient portfolios, taking into account only risky assets in fixed proportions.
Explanation:
Explanation
The correct answer is A because:
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Capital Market Line (CML) represents portfolios that combine the market portfolio (which contains all risky assets) with the risk-free asset in varying proportions. It shows the risk-return trade-off for efficient portfolios that include the risk-free asset.
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Efficient Frontier (EF) represents all possible combinations of efficient portfolios that contain only risky assets in varying proportions. It shows the optimal risk-return combinations without considering the risk-free asset.
Key Differences:
- CML includes the risk-free asset, while EF considers only risky assets
- CML is a straight line from the risk-free rate to the market portfolio (tangent point on EF)
- CML represents the best possible risk-return combinations when investors can borrow or lend at the risk-free rate
- EF represents the best possible risk-return combinations using only risky assets
The slope of the CML represents the market price of risk, showing the additional return per unit of additional risk that the market offers.
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