Financial Risk Manager Part 1
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The Capital Market Line (CML) is the line that represents all the portfolios that an investor can create once we allow for a risk-free asset. The CML is derived from the Capital Allocation Line (CAL), which shows the risk and return trade-off for a specific investor. However, the CML is a special case of the CAL where all investors have homogeneous expectations of risk and return. This means that all investors agree on the expected returns, variances, and covariances of all assets. Therefore, they all hold the same optimal risky portfolio, which when combined with a risk-free asset, results in the CML. The CML is a critical component of the modern portfolio theory and plays a significant role in determining an investor's optimal portfolio.
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Explanation:
Explanation
The correct answer is C - The Capital Market Line (CML).
Key Concepts:
Capital Market Line (CML):
- Represents all portfolios that combine the risk-free asset with the market portfolio
- Is a special case of the Capital Allocation Line (CAL) where all investors have homogeneous expectations
- Shows the risk-return tradeoff for efficient portfolios (combinations of risk-free asset and market portfolio)
- All investors hold the same optimal risky portfolio (market portfolio) when combined with risk-free asset
Why Other Options Are Incorrect:
A - Efficient Frontier:
- Represents optimal portfolios of only risky assets
- Does not include risk-free asset combinations
- Shows highest return for given risk level or lowest risk for given return level
B - Capital Allocation Line (CAL):
- Shows risk-return tradeoff for specific investor's optimal risky portfolio
- Not necessarily the market portfolio (depends on individual investor's expectations)
- CML is a special case of CAL with homogeneous expectations
D - Beta:
- Measures systematic risk/sensitivity to market movements
- Used in CAPM to determine expected returns
- Not a line or range representing portfolio combinations
Key Distinction:
The CML specifically represents portfolios that include the risk-free asset, while the efficient frontier represents portfolios of only risky assets. The CML is tangent to the efficient frontier at the market portfolio point.
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