When we add a risk free asset to a portfolio P we get a CAL. If we make that line tangent to the efficient frontier, is that line the new efficient frontier, or is it still just a CAL that is tangent to the efficient frontier?
The curve containing only risky assets is the Markowitz efficien frontier. By adding a risk free asset to the tangency portfolio, you get the optimal CAL which becomes the new efficient frontier.
I think it is still just a CAL that is tangent to the efficient frontier.
If the CAL becomes the NEW effiicient frontier No. 1, does that mean you can add another CAL to the tangency of the NEW efficient frontier No.1 to derive another NEWER efficient frontier No. 2 and the process is endless?
CAL is a straight line. A tangent to that is just that same line.
True. But the thing is CAL is CAL, frontier is frontier.
Efficient frontier is there because it helps to find out the maximum return of a 100% risky assets for every given level of risk.
CAL exists to help determine the proper allocation of risk-free asset and risk assets to cater to the risk -aversion preference of the investor.
I think they cannot be the same by definition.
Efficient frontier is the set of portfolios that dominates others in mean-variance analysis.
CAL dominates the Markowitz-efficient frontier. Hence, CAL is the new efficient frontier.
“24 Note that when we expand the set of assets to include the risk-free asset, an investor’s CAL becomes the efficient frontier defined in relation to the expanded set of assets. The efficient frontier of risky assets is the efficient frontier considering risky assets alone. It is critical to understand that the efficient frontier is always defined in relationship to a specified set of assets.” (Institute 384) Institute, CFA. Level II 2013 Volume 6 Derivatives and Portfolio Management. John Wiley & Sons (P&T), 7/9/2012. .
I remeber I encountered the question regarding the shapre of efficient frontier after adding the risk-free asset.
I was convinced that it is a straight line along all the way. But the answer said that it is a straight line from the intercept to the tangency point with efficient frontier and then it coincides with the ‘old’ efficient frontier.
Sounds strage… Is that right??
I thought CML was the new efficient frontier not CAL
I’m gonna answer my own question. It is right when borrowing at risk free rate is not possible. If it is, then efficient froniter is straight line even past point of tangency. For reference page 385.
[quote=“Hanna”]
Efficient frontier is the set of portfolios that dominates others in mean-variance analysis.
CAL dominates the Markowitz-efficient frontier. Hence, CAL is the new efficient frontier.
[quote]
Got it. Thansk a lot.
One more question, if that’s the case, what’s wrong with option B in the CFA Mock AM Q21?
Good work Xander. It looks to me that It’s because the CAL is NOT the new efficient frontier. On page 384 of portfolio concepts it states that of the “three important general principles concerning the risk-return trade-off” is that “The CAL is tangent to the efficient frontier of risky assets.” If the CAL was the new efficient frontier it would have said in that bullet point that it is the new efficient frontier. The efficient frontier only refers to the minimum variance frontier of portfolio of risky assets.
So the statement by @Cinderella is correct with a tiny modification:
The (upper) curve containing only risky assets is the Markowitz efficient frontier. By adding a risk free asset to the tangency portfolio, you get the optimal CAL which becomes the new efficient frontier ( of the risky assets AND risk-free asset ).
@pmond, You are right too when you say “The CAL is tangent to the efficient frontier of risky assets”. I guess maybe they will have to issue an errata on this (either on Mock or the Text)…if I’m not missing something…
hmm…well regardless of how you want to view it, C is the most correct since option B is in the same sentence as option A which is clearly wrong. Going to let this one go lol.