Practice Question 7 The market portfolio plays an important role because: A.

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Correct Answer: B The other answers are untrue. Practice Question 8 The dominant line is the one that is tangent to the efficient frontier. All investors should target points along this line depending on their risk preferences. This line is referred to as the: A. When combined with the risk-free asset, no other portfolio along the efficient frontier provides a higher expected reward-to-risk ratio than the tangency portfolio.

Investors can have different CALs. When combined with the risk-free asset, the optimal risky portfolio should always be the tangency portfolio. III: This is because the portfolio maximizes the investor's reward-to-risk ratio.

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Practice Question 10 Consider the following three statements. Which are true? The risk-free asset has a variance of 0 II.

Any portfolio containing the risk-free asset has zero risk III. The risk-free asset has a correlation of 0 with any risky asset Correct Answer: I and III By definition, the risk-free asset has a variance and a standard deviation of 0. Portfolios containing the risk-free asset will have risk proportionate to their exposure in risky assets. Since its return does not vary, the risk-free asset is uncorrelated with any risky asset.

Practice Question 11 In the presence of a risk-free security, the efficient frontier. In the presence of a risky asset, the efficient frontier of risky assets is dominated by a new efficient frontier consisting of the risk-free security and the tangent portfolio found by joining the risk-free security with a point on the efficient frontier of risky securities where the line has the highest slope.

Login Username. Portfolio Concepts d. Subject 4. The efficient frontier only considers the investments in risky assets. However, investors may choose to invest in a risk free asset, which is assumed to have an expected return commensurate with an asset that has no standard deviation i. That is, a risk-free asset's expected return is entirely certain, and is known as the risk-free rate of return RFR. Therefore, a risk-free asset lies on the vertical axis of a portfolio graph. The risk free asset is important to the capital asset pricing model.

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First, pick a risky stock or risky portfolio A. Hint: start with one that is already on the efficient frontier since you know that these portfolios dominate everything below them in terms of return offered for risk taken. Now combine the risk-free asset with portfolio A. Remember, the combination of the risk-free asset and portfolio A will be a straight line. Observe that any combination on the line R f A dominates the portfolios below it.

But any combination on the line R f B will dominate R f A. Because you always get more return for a given amount of risk.

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## Bayesian inference for the tangent portfolio

You can keep getting better portfolios by moving up the efficient frontier At point M you reach the best combination. The R f M line dominates everything else in terms of return offered for the level of risk taken. The introduction of a risk-free asset changes the efficient frontier into a straight line.

Since the line is straight, the math implies that any two assets falling on this line will be perfectly positively correlated with each other. Between R f and M investors hold both the risk-free asset and portfolio M.

## Capital Allocation Line (CAL) and Optimal Portfolio

This means investors are lending some of their funds buying the risk-free asset. This means they are borrowing funds to buy more of portfolio M. This represents a levered position. Now, the line R f -M dominates all portfolios on the original efficient frontier. Thus, the CML becomes the new efficient frontier. Market risk premium: E R M - R f. It is also called the market price of risk because it indicates the market risk premium for each unit of market risk. That mean you have to use corner portfolios with a less than optimal Sharpe ratio. Pop - I agree with most of what you are saying.

As with any efficient frontier, you want to get into the northwest corner high return, low risk. Because the CML plots above the frontier itself you are getting a better risk adjusted return. The only thing it would allow you to do is adjust the portfolio to accepted risk or required return in optimal conditions. Only changes as you move from the non-optimal corner portfolio to the CML. This sounds right to me. For risk levels below the tangent portfolio, you combine the tangent portfolio with the RFR.

There may be another theory that concludes that the market portfolio is necessarily the most efficient, but I think CAPM is the only one that asserts it strongly. Skip to main content. Be prepared with Kaplan Schweser. Twitter Facebook LinkedIn. Search form. PhillyBanker May 28th, pm. Bankin' May 28th, pm. Charterholder AF Points. I agree with ozzy here. I guess you could look at it that way…..