LOS d, (Part 2): Explain the capital allocation and the capital market lines (CAL and CML), explain the relation between them, and calculate the values of one of the variables given the values of the remaining variables. fficeffice" />
Q1. Which of the following statements regarding the capital market line (CML) is least accurate? The CML:
A) implies that all portfolios on the CML are perfectly positively correlated.
B) dominates everything below the line on the original efficient frontier.
C) slope is equal to the expected return of the market portfolio minus the riskfree rate.
Correct answer is C)
The slope of the CML = (the expected return of the market ? the riskfree rate) / (the standard deviation of returns on the market portfolio)
Because the CML is a straight line, it implies that all the portfolios on the CML are perfectly positively correlated.
Q2. The capital market line (CML) is the capital allocation line with the:
A) global minimumvariance portfolio as the tangency portfolio.
B) market portfolio as the tangency portfolio.
C) market portfolio as the global minimumvariance portfolio.
Correct answer is B)
The CML is the capital allocation line (ffice:smarttags" />CAL) with the market portfolio as the tangency portfolio.
Q3. Which of the following statements most accurately describes the capital allocation line (CAL) and the capital market line (CML)? The market portfolio:
A) always lies on both the CAL and the CML.
B) may lie on the CML, but it always lies on the CAL.
C) may lie on the CAL, but it always lies on the CML.
Correct answer is C)
When a minimum variance frontier is constructed in risk return space (i.e., yaxis = expected return, xaxis = standard deviation), the capital allocation line is the line emanating from the riskless return through the highest point of tangency with the minimum variance frontier. When the point of tangency is the market portfolio, the capital allocation line is the capital market line.
Q4. The capital allocation line (CAL) with the market portfolio as the tangency portfolio is the:
A) capital market line.
B) minimum variance line.
C) security market line.
Correct answer is A)
The capital market line is the capital allocation line with the market portfolio as the tangency portfolio.
Q5. If a riskfree asset is part of the investment opportunity set, then the efficient frontier is a:
A) straight line called the capital allocation line (CAL).
B) curve called the minimumvariance frontier.
C) curve called the efficient portfolio set.
Correct answer is A)
If a riskfree investment is part of the investment opportunity set, then the efficient frontier is a straight line called the capital allocation line (CAL), whether or not risky asset correlations are equal to one. The yintercept of the CAL is the riskfree rate. The CAL is tangent to the minimumvariance frontier of risky assets.
Q6. Which of the following does NOT describe the capital allocation line (CAL)?
A) The CAL is tangent to the minimumvariance frontier.
B) It runs through the global minimumvariance portfolio.
C) It is the efficient frontier when a riskfree asset is available.
Correct answer is B)
If a riskfree investment is part of the investment opportunity set, then the efficient frontier is a straight line called the capital allocation line (CAL). The CAL is tangent to the minimumvariance frontier of risky assets; therefore, it cannot run through the global minimumvariance portfolio.
Q7. The equation of the capital market line (CML) says that the expected return on any portfolio equals the:
A) riskfree rate plus the product of the market risk premium and the market's portfolio standard deviation.
B) riskfree rate plus the product of the market price of risk and the market's portfolio standard deviation.
C) riskfree rate plus the product of the market price of risk and the portfolio's standard deviation.
Correct answer is C)
The CML is the capital allocation line with the market portfolio as the tangency portfolio. The equation of the CML is:
E(R_{P}) = R_{F} + [(E(R_{M}) – R_{F})/s_{M}] s_{p}
where: E(R_{M}) = the expected return on the market portfolio, M s_{M} = the standard deviation of the market portfolio, M R_{F} = the riskfree return
The intercept is the riskfree rate, R_{F}. The slope is equal to [(E(R_{T}) – R_{F}) / s_{T}], where [E(R_{T}) – R_{F}] is the expected risk premium on the tangency portfolio.
Q8. The slope of the capital allocation line is equal to:
A) the expected return on the tangency portfolio divided by the standard deviation of the tangency portfolio.
B) the expected risk premium on the tangency portfolio divided by the standard deviation of the tangency portfolio.
C) the inverse of the slope of the security market line.
Correct answer is B)
Because the capital allocation line is a straight line, we can express it as the equation of a straight line (y = mx + b) where the dependent variable, y, is the expected return E(R_{p}) and the independent variable, x, is the standard deviation s_{p}:
E(R_{P}) = R_{F} + [(E(R_{T}) – R_{F})/s_{T}] s_{p}
where: E(R_{T}) = the expected return on the tangency portfolio, T s_{T} = the standard deviation of the tangency portfolio, T R_{F}= the riskfree return
The slope is equal to [(E(R_{T}) – R_{F})/s_{T}], where [E(R_{T}) – R_{F}] is the expected risk premium on the tangency portfolio.
Q9. The intercept of the capital market line is the:
A) expected market return.
B) expected return on the tangency portfolio.
C) riskfree rate.
Correct answer is C)
The capital market line (CML) is the capital allocation line with the market portfolio as the tangency portfolio. The equation of the CML is:
E(R_{P}) = R_{F} + [(E(R_{M}) – R_{F})/s_{M}] s_{p}
where: E(R_{M}) = the expected return on the market portfolio, M s_{M} = the standard deviation of the market portfolio, M R_{F} = the riskfree return
The intercept is the riskfree rate, R_{F}. The slope is equal to [(E(R_{T}) – R_{F})/s_{T}], where [E(R_{T}) – R_{F}] is the expected risk premium on the tangency portfolio.
Q10. The best possible riskreturn tradeoff attainable, given the investor’s expectations of expected returns, variances, and covariances, is represented by the:
A) the slope of the minimumvariance frontier at the global minimumvariance portfolio.
B) slope of the capital allocation line (CAL).
C) standard deviation of the market portfolio.
Correct answer is B)
We can interpret the slope coefficient [(E(R_{T}) ? R_{F}) / s_{T}] of the CAL the same way we do the slope of any straight line (it’s the change in E(R_{T}) for a one unit change in s_{T}). Thus, it represents the riskreturn trade from moving along the CAL and how much additional expected return do we get for a oneunit increase in risk. Because the tangency portfolio T is the best portfolio, the slope of the CAL line represents the best possible riskreturn tradeoff attainable, given the investor’s expectations of expected returns, variances, and covariances.
Q11. Portfolio Management Associates (PMA) provides asset allocation advice for pensions. PMA recommends that all their pension clients select an appropriate weighting of the riskfree asset and the market portfolio. PMA should explain to its clients that the market portfolio is selected because the market portfolio:
A) maximizes the Sharpe ratio.
B) maximizes return and minimizes risk.
C) maximizes return.
Correct answer is A)
The risk and return coordinate for the market portfolio is the tangency point for the capital market line (CML). The CML has the steepest slope of any possible portfolio combination. The slope of the CML is the Sharpe ratio. Therefore, the Sharpe ratio is highest for the market portfolio.
Q12. Investment Management Inc. (IMI) uses the capital market line to make asset allocation recommendations. IMI derives the following forecasts:
 Expected return on the market portfolio: 12%
 Standard deviation on the market portfolio: 20%
 Riskfree rate: 5%
Samuel Johnson seeks IMI’s advice for a portfolio asset allocation. Johnson informs IMI that he wants the standard deviation of the portfolio to equal one half of the standard deviation for the market portfolio. Using the capital market line, the expected return that IMI can provide subject to Johnson’s risk constraint is closest to:
A) 6.0%.
B) 8.5%.
C) 7.5%.
Correct answer is B)
The equation for the capital market line is:
Johnson requests the portfolio standard deviation to equal one half of the market portfolio standard deviation. The market portfolio standard deviation equals 20%. Therefore, Johnson’s portfolio should have a standard deviation equal to 10%. The intercept of the capital market line equals the risk free rate (5%), and the slope of the capital market line equals the Sharpe ratio for the market portfolio (35%). Therefore, using the capital market line, the expected return on Johnson’s portfolio will equal:
Q13. If an investors’ portfolio lies on the capital market line (CML) at the point where the CML touches the efficient frontier then this implies the investor has:
A) 100% of their funds invested in the market portfolio.
B) less than 100% of their money invested in the market portfolio.
C) a larger percentage of their money invested in the market portfolio and have loaned the remaining amount at the riskfree rate.
Correct answer is A)
Portfolios that are on the CML where the CML touches the efficient frontier implies that 100% of investors funds should be invested in the market portfolio to achieve greatest utility.
Q14. Adrian Jones is the portfolio manager for Asset Allocators, Inc., (AAI). Jones has decided to alter her framework of analysis. Previously, Jones made recommendations among efficient portfolios of risky assets only. Now, Jones has decided to make recommendations that include the riskfree asset. The efficient frontier for Jones has changed shape from a:
A) curve to a line.
B) curve to the thick curve.
C) line to a curve.
Correct answer is A)
Initially, Jones selected only efficient portfolios comprising risky assets. Formally, Jones selected portfolios along the Markowitz efficient frontier (a curve). When Jones decided to add the riskfree asset, her efficient frontier changed from a curve (the Markowitz efficient frontier) to a line (the capital market line). The capital market line starts at the riskfree rate and extends along (tangent to) the Markowitz curve.
