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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TTanishq
A
The Efficient Frontier refers to the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal, because they do not provide enough return for the level of risk. Portfolios that cluster to the right of the efficient frontier are also sub-optimal, because they have a higher level of risk for the defined rate of return.
B
The Capital Allocation Line (CAL) is a line created in graph where on one axis there is portfolio risk (standard deviation), and on another axis there is expected return. This line illustrates all possible mixes between risky and risk-free assets, but it does not represent portfolios including only risky assets as required by our question.
C
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.
D
Beta measures an investment's sensitivity to market movements and it's used in CAPM model to determine an asset's expected returns based on its beta exposure to market returns. It does not represent a range or line where different portfolios can be constructed with inclusion of a risk-free asset.
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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