Correct Answer: A

Explanation:

In portfolio theory, when you combine a risk-free asset with a risky asset, you create a straight line in the risk-return space known as the Capital Allocation Line (CAL). This line represents all possible combinations of the risk-free asset and the risky portfolio.

Key Concepts:

1. Capital Allocation Line (CAL):

   • Shows the risk-return trade-off when combining a risk-free asset with a risky portfolio
   • Is a straight line in the expected return-standard deviation space
   • The slope of the CAL is the Sharpe ratio: (E(R) - R_f) / σ

2. Markowitz Efficient Frontier:

   • This represents the set of optimal portfolios that offer the highest expected return for a given level of risk
   • Only includes risky assets (no risk-free asset)
   • Is curved, not straight

3. Indifference Curves:

   • These represent an investor's preferences for risk and return
   • Show combinations of risk and return that provide equal utility to the investor
   • Are subjective and vary by investor

Why other options are incorrect:

• Option B: The Markowitz efficient frontier only includes risky assets, not combinations with the risk-free asset.
• Option C: Indifference curves represent investor preferences, not the actual combinations available in the market.

Portfolio Theory Context: The combination of a risk-free asset with a risky portfolio allows investors to achieve any point along the CAL, which represents the best possible risk-return trade-off available in the market. The optimal portfolio for an investor is found where the CAL is tangent to the investor's highest indifference curve.