Financial Risk Manager Part 1

Explanation

When we introduce a risk-free asset into portfolio construction, the line that shows all possible combinations of the risk-free asset and the market portfolio is called the Capital Allocation Line (CAL).

Key Points:

• Efficient Frontier: Shows the set of optimal portfolios that offer the highest expected return for a defined level of risk, but does NOT include the risk-free asset
• Capital Market Line (CML): A special case of the CAL when the market portfolio is used as the risky asset
• Security Market Line (SML): Shows the relationship between expected return and systematic risk (beta) in the Capital Asset Pricing Model
• Capital Allocation Line (CAL): The correct answer - represents all possible combinations of a risk-free asset and any risky portfolio

The CAL has a linear relationship where the slope represents the Sharpe ratio of the risky portfolio. As we move along the CAL, we're adjusting the proportion of investment between the risk-free asset and the risky portfolio.