Financial Risk Manager Part 1
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The line that shows all portfolios that an investor can create once we allow for a risk-free asset is called the:
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TTanishq
A
Efficient frontier
B
Capital market line
C
Security market line
D
Capital allocation line
Explanation:
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.
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