CFA Level 1: False Statement About Risk-Free Asset and Efficient Frontier

False Statement About Risk-Free Asset and Efficient Frontier

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Question

Consider the following graph of the risk-free asset Rf and the efficient frontier. The letters K, 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 is FALSE?

Answers

A. The area to the right of point S represents unsystematic risk, or risk that is not paid for.

B. Assets W and Z are perfectly positively correlated with each other.

C. By definition of the capital market line (CML), portfolio K is possible, but not the most efficient because it does not fall on the efficient frontier and is overvalued.

D. Investors on the capital market line (CML) to the right of M are leveraged and hold more than 100% of portfolio M.

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Explanations

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A. B. C. D.

By definition, all stocks and portfolios other than M, the market portfolio, fall on or below the CML. Thus, K is not a possible portfolio on this graph. Overvaluation/ undervaluation is usually expressed in relation to the SML (security market line). The other statements are true.

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