Jeret Behr is a member of a Level 1 CFA Study Group. Last week, he was assigned the reading on asset pricing models and is to prepare a "tough" question on the capital market line (CML). He constructs the following graphical representation of the CML and drafts the following four statements about the graph. The letters
W, X Y, and Z represent risky portfolios. Portfolio M is the market portfolio. The linesRfXandRfYrepresent the combination of the risk-free asset and the risky portfolio.
Which of the following statements about the above graph did Behr make TRUE?
Click on the arrows to vote for the correct answer
A. B. C. D.Explanation
This selection is true (or not false). By definition, all portfolios below the CML are inefficient in that they do not give enough return for their risk. Investors could do better by combining the risk-free asset with the portfolio.
The area to the left of point S represents systematic or undiversifiable risk. Investors are compensated for this risk. The correct label for the x-axis is total risk, or standard deviation. The CML plots total risk (systematic plus unsystematic risk) versus expected return; the security market line (SML) plots beta (or systematic risk) versus expected return. Portfolio Z is created by lending at the risk-free rate and holding less than 100% of Portfolio M. Investors in portfolios to the left of the market portfolio, M, are invested in less than 100% of M.