Efficient frontier and CML

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Questions and Answers

According to the text, what does the Capital Asset Pricing Model (CAPM) estimate?

Standard deviation of a risky asset portfolio

Expected return of a risky asset based on its standard deviation

Expected return of an asset based on its market risk and the risk-free rate (correct)

The systematic risk of a risk-free asset

What is the main focus of the Capital Market Theory (CMT) as described in the text?

Explaining asset pricing based on multiple risk factors

Understanding risk-return relationships, diversification, and market efficiency (correct)

Maximizing return for a given level of risk

Estimating the cost of capital and evaluating portfolio performance

What is the key assumption of the Capital Asset Pricing Model (CAPM) mentioned in the text?

Investors have access to the same information

Prices in efficient markets reflect all available information

Investors are rational and risk-averse (correct)

Markets are efficient

Which theory within Capital Market Theory (CMT) deals with constructing optimal portfolios by minimizing risk for a given expected return?

Modern Portfolio Theory (MPT) Signup and view all the answers

What does combining a risk-free asset with a portfolio of risky assets result in, according to the text?

An increase in the portfolio's expected return Signup and view all the answers

What is the critical factor to consider when selecting investments according to the Markowitz portfolio model?

Correlation coefficients among assets Signup and view all the answers

How does combining assets or portfolios with low-positive or negative correlation affect the risk level of the portfolio?

Reduces the risk level Signup and view all the answers

What does the efficient frontier define in the context of the Markowitz portfolio model?

The set of portfolios with the highest expected return for each given level of risk Signup and view all the answers

In a large portfolio, what are the important factors for the standard deviation of the portfolio?

Both standard deviations for individual investments and covariance between rates of return for all pairs of assets Signup and view all the answers

What does Markowitz's portfolio model show about the expected rate of return for a portfolio?

It is equal to the expected return for the individual investments in the portfolio Signup and view all the answers

According to Capital Market Theory, what is the risk-free asset's standard deviation and rate of return?

Standard deviation is zero, rate of return is the risk-free rate Signup and view all the answers

What does the Capital Market Equation state about investors' returns?

Investors' returns equal risk-free rate plus compensation for risk units they accept Signup and view all the answers

How does diversification affect risk according to Capital Market Theory?

Diversification reduces standard deviation, assuming imperfect correlations among securities Signup and view all the answers

What does the Capital Market Graph represent?

Investors' expected returns along efficient frontier from risk-free rate Signup and view all the answers

What is the relationship between the market portfolio and systematic risk according to Capital Market Theory?

Market portfolio contains all risky assets, completely diversified, only systematic risk remains, measured by systematic risk factors such as money supply growth, interest rate volatility Signup and view all the answers

What is the primary purpose of the efficient frontier?

To minimize risk for a given expected return Signup and view all the answers

In mean-variance optimization, what is the approach to forming portfolios?

Minimizing portfolio risk for a given expected return Signup and view all the answers

How are larger expected return goals related to risk on the efficient frontier?

They require higher levels of risk Signup and view all the answers

What does the slope of the efficient frontier indicate as risk increases?

Equal increments of risk give diminishing increments of expected returns Signup and view all the answers

How do two investors choose the same portfolio from the efficient set?

If their utility curves are identical Signup and view all the answers

Study Notes

The efficient frontier is the set of risk-minimizing portfolios for each potential expected return goal. It is the set of portfolios with the maximum rate of return for every given level of risk.
The purpose of the efficient frontier is to help investors decide the weights of all possible asset holdings in their portfolio to achieve their expected return goal in the best way.
The best way is one that is capable of producing the specific expected return objective while minimizing risk, assuming investors are risk-averse.
The efficient frontier consists of various combinations of assets with different levels of risk and expected returns.
Larger expected return goals require higher levels of risk.
Mean-variance optimization is an approach to forming portfolios that requires investors to minimize portfolio risk for a given expected return.
The investor needs to select investment weights that minimize portfolio risk while also producing an expected return equal to their return goal and ensuring all investment weights add up to 1.
There is no way to combine the assets in the portfolio to achieve a lower-risk allocation strategy than the mean-variance optimal weights for a given return goal.
Investors' willingness to take risk determines which specific portfolio they should select along the efficient frontier based on their utility function.
The slope of the efficient frontier decreases as risk increases, meaning equal increments of risk give diminishing increments of expected returns.
An individual's investor utility curve specifies the trade-offs they are willing to make between expected return and risk.
Two investors will choose the same portfolio from the efficient set only if their utility curves are identical. The efficient frontier and investor utility curves determine which particular portfolio on the efficient frontier best suits an individual investor.

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Description

Test your understanding of the Capital Market Theory and the CAPM Model, which extends the Markowitz efficient frontier into a model for valuing all risky assets and allows the determination of the required rate of return for any risky asset.