We know that as we move up along the CAL, the weightage of Risky asset keeps going up and that of Risk Free asset coming down. At the Tangent, is it that the weightage of Risky asset is 100%? If so, then will not everybody chose Tangency as the most preferred portfolio, with that offering the best Reward to Risk ratio? We know that for Regression, the slope is covar(X,Y)/var(X). How is that holding true for the slope calculated for CAL, which is (Expected Return on Risky asset - RFR)/SD of Risky asset.
I recently read this topic but my understanding CAL is the the portfolio that will offer maximum reward/risk combination of assets. It’s a combination of the risk free assets and risky assets, market port, that will also be tangent efficient frontier. But under the assumption of the efficient market theories CML (straight line) will trump all efficient frontier portfolio options (curve).
Hi Jgrandits, Thanks for the post, but are you saying that Tangency Portfolio will always have 100% Risky asset and 0% Risk Frees asset? Pls confirm.
The tangency portfolio only has risky assets… no risk free asset.
When you combine a risky asset and a risk free asset, you derive a very important relation; the efficient frontier turns into a straight line. This is intuitive because when a portfolio has a risk free asset and a risky asset, the risk of the portfolio is simply presented by the proportion of risky asset. If risky asset’s weight = 0, thee is no risk. And the return of portfolio is the risk free rate. As you increase the weight of the risky asset, the return increases at a constant rate and so does the risk. Therefore the efficient frontier becomes a straight line. When you have to combine a risky asset with a risk free asset, you choose the tangency portfolio because it maximizes the reward/risk ratio. Think along the CAL; for every incrmental unit of risk the investor bears, he is compensated by the highest return for evey such unit. Now, about your question. The investor is indifferent about chosing any combination on the CAL. It’s not about choosing portfolios, but choosing the weights of risky asset and riskfree asset in the tangency portfolio. And chosing the weights is simply a matter of how risk averse the investor is. If investor is less risk averse, he may consider being short on the RF and investing more than 100% in the risky asset. And reward/risk ratio is the slop of the equation. Risk free rate is the intercept. Investor is compensated for his risk taking ability. If he chooses not to take risk, he earns RFR. Therefore expected return is given as RFR + (reward/risk ratio)*risk of the portfolio. Slope = reward risk ratio of tangency portfolio because that’s the rate at which every unit of risk on the CAL has been priced. I hope this makes sense now.
Thanks Areyouserious, its much clearer now. Since your concept is clear, let me ask you this too, can you explain as to how they get to the formula of variance in Market Model (the one with Beta). Many thanks in advance.