Financial Risk Manager Part 1
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Julia and Frank are two traders that have recently joined the New York Stock Exchange (NYSE). During their daybreak, they discussed their understanding of the Capital Market Line (CML) and Market Portfolio Theory.
Julia, who is a senior trader, stated that the capital market line (CML) is the tangent line drawn from the point of the risk-free asset to the feasible region for risky assets, and all investors invest in some combination of risk-free assets and market securities, which lies on the CML.
Frank added that the market portfolio is a universally agreed upon optimal risky portfolio that lies on the CML.
Determine if the explanations of Julia and Frank are correct.
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TTanishq
A
Julia is correct, and Frank is also correct.
B
Julia is correct, but Frank is incorrect.
C
Julia is incorrect, but Frank is correct.
D
Julia is incorrect, and Frank is also incorrect.
Explanation:
Explanation
Both Julia and Frank are correct in their explanations about the Capital Market Line (CML) and Market Portfolio Theory.
Julia's Statement Analysis:
- "CML is the tangent line drawn from the point of the risk-free asset to the feasible region for risky assets" - This is correct. The CML is indeed the line that connects the risk-free rate to the tangency point on the efficient frontier of risky assets.
- "All investors invest in some combination of risk-free assets and market securities, which lies on the CML" - This is also correct. According to the Capital Asset Pricing Model (CAPM), all investors will hold some combination of the risk-free asset and the market portfolio, and all such combinations lie on the CML.
Frank's Statement Analysis:
- "The market portfolio is a universally agreed upon optimal risky portfolio that lies on the CML" - This is correct. The market portfolio represents the optimal risky portfolio that all investors agree upon under the assumptions of CAPM, and it lies at the tangency point where the CML touches the efficient frontier.
Key Concepts:
- Capital Market Line (CML): Shows the risk-return trade-off for efficient portfolios that combine the risk-free asset with the market portfolio
- Market Portfolio: The portfolio that contains all risky assets in proportion to their market values
- Separation Theorem: All investors, regardless of risk preferences, will hold the same risky portfolio (market portfolio) and only differ in their allocation between the risk-free asset and the market portfolio
Therefore, both statements are accurate descriptions of modern portfolio theory and the Capital Asset Pricing Model.
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