Financial Risk Manager Part 1

Explanation

The correct answer is A because:

• 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.

• 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.