According to the capital asset pricing model… A. an investor who is risk adverse should hold at least some of the risk free asset in his portfolio B. a stock w high risk, measured by the std dev of returns, will have high expected returns C. any investor who takes on risk will hold some of the market portfolio. ------- I picked A but the correct answer is C. I understand why C is correct… but can’t A also be the correct answer? Since the CML starts at RFR and goes up with more risky assets, correct? So I’m assuming here that the MOST risk adverse investor will hold ALL risk free asset and the LEAST risk free investor will hold 100% market portfolio (where the CML intersects with the efficient frontier). Can someone please help explain what I am not understanding correctly?
Does the question actually reference the CML or is it entirely CAPM? CAPM alone is not going to provide you with the information contained in option A. Also, a risky investor would begin to borrow at the RFR beyond the intersection point of CML/Efficient Frontier crossover. Lend below, borrow above.
When you look at the Markowitz efficient frontier,each point represents some amount of return and risk (it doesn’t intersect at any axis, indicating there is some amount of risk present). The return can be increased and risk can be decreased to a certain point by borrowing at RFR and investing in Market Portfolio. Thus, to begin with, each investor ALREADY holds some risky asset. (see the Markowitz curve) Since all investors are risk averse (each prefers a higher return for same amount of risk or a lower risk for same amount of return), he will enhance the portfolio by selecting a point on CML according to his utility curve. Again, to begin with, EACH investor already holds SOME risky asset (he is merely enhancing his portfolio by investing in RFR).
you are confusing the EF and CML, yohji. C is correct, you said you understand that okay. A is not correct because an investor could be risk averse, and have a low utility line which gives him a low risk low return portfolio. he does not have to hold RFR just to reduce risk, he can reduce risk by have a lower utility, which will make the CML steeper, if you can visualize that. remember that the only efficient portfolio is the market portfolio so all individual stocks plot below the CML. the SML you can plot individual stocks above or below it.
^smileyface, essentially your point is showing why answer C is correct… but can you show me why is answer A wrong? @chuckrox: the question is referencing CAPM. guys i feel like this whole capm, cml, sml stuff is one of the most convoluted parts of the CFA… its so theoretical im really struggling to understand it. essentially this is how i see the theories: Markowitz came up with theory of efficient frontier, which is basically optimum levels of return per unit of risk. CML expounds upon concept of efficient frontier and adds risk free asset… able to borrow at risk free rate which results in a more accurate view of risk/return profiles. CML and efficient frontier are tangent at point M, the market portfolio, which is optimum risk/return portfolio with no borrowing (all $ invest in mkt portfolio, nothing in risk free asset). CAPM and SML in my mind is basically the same thing… showing a required level of return based on amt of risk (beta). CAPM is numerical while SML is visual. Now is all that correct? I think in my original answer… I got CAPM and CML confused. But now that I’m looking back at the question and what I typed above… what does CAPM have to do with a portfolio? I thought CAPM / SML deals more with single securities vs CML which deals more with portfolios…
@yohji: A. an investor who is risk adverse should hold at least some of the risk free asset in his portfolio As i said before, every investor DEFINITELY holds some amount of risky asset. Maybe consider it as an assumption of Markowitz frontier but that’s the way it is. (unrealistic, yes, but then so are most assumptions of efficient frontier) Having said that, no matter how much risk free assets he accumulates, he would still hold SOME amount of risky asset as required by Markowitz and the portfolio risk can never truly be 0. (maybe 0.00001 but not 0!) If you look at practical application, the assumption that a risk free asset exists itself is flawed. T-Bonds/ Bills are subject to inflation risk, interest rate fluctuation etc. (just look at the way bonds have reacted in past 5 years!). Thus even bonds have systematic (market) risk! Don’t sweat much over PM…the weightage is not worth the worry.
Just because an investor is risk adverse doesn’t mean that they have to hold the risk free asset… Risk aversion simply means that for a given level of return, the investor will select the option with the least risk. Any point on the CML below the optimum portfolio includes some proportion of the risk free asset and the market portfolio. Once you move past the point where CML is tangent to Efficient frontier, the investor is borrowing at risk free rate and investing the borrowed funds in market portfolio. Hence A can’t be right because the investor does not necessarily have some proprtion of risk free asset in their portfolio. Think this might answer the question, if anyone thinks this is wrong please let me know…