Optimal Risky Portfolio - Capital Allocation Line

CFA Level I
#1

How is the optimal risky portfolio determined when computing the capital allocation line.

#2

It’s where the CAL intersects the efficient frontier.

The CAL that you want is the CML – the capital market line – which is the CAL with the highest Sharpe ratio; it’s tangent to the efficient frontier.

#3

With risk free asset a known return, we are able to create a CAL line that is able to touch the efficient frontier at a given point, and that given point is the optimal risky portfolio?

#4

If the CAL you are using is, in fact, the CML (i.e., the CAL with the highest Sharpe ratio), then that point is the optimal (pure) risky portfolio.

#5

What does the CML tell us? In other words, how are we supposed to interpret the CML?

#6

It tells you:

  • Which portfolio is the market portfolio (the point where the CML is tangent to the efficient frontier)
  • What the optimal Sharpe ratio is (the slope of the CML)
  • What portfolio should be chosen by any investor given either:
    • Their minimum required return, or
    • Their maximum risk level
#7

What about the other points on the CML (aside from the point tangent to the efficient frontier)? What are the other points on the CML supposed to tell us?

#8

Those are the other portfolios that investors should choose given either:

  • Their minimum required return, or
  • Their maximum risk level

I mentioned them in my earlier reply.