Reading 68: LOS d (Part 2) ～ Q11 - 14

11．Adrian Jones is the portfolio manager for Asset Allocators, Inc., (AAI). Jones has decided to alter her framework of analysis. Previously, Jones made recommendations among efficient portfolios of risky assets only. Now, Jones has decided to make recommendations that include the risk-free asset. The efficient frontier for Jones has changed shape from a:

A)   line to a curve.

B)   line to a thick band.

C)   curve to a line.

D)   curve to the thick curve.

The correct answer was C)

Initially, Jones selected only efficient portfolios comprising risky assets. Formally, Jones selected portfolios along the Markowitz efficient frontier (a curve). When Jones decided to add the risk-free asset, her efficient frontier changed from a curve (the Markowitz efficient frontier) to a line (the capital market line). The capital market line starts at the risk-free rate and extends along (tangent to) the Markowitz curve.

12．If an investors’ portfolio lies on the capital market line (CML) at the point where the CML touches the efficient frontier then this implies the investor has:

A)   100% of their funds invested in the market portfolio.

B)   less than 100% of their money invested in the market portfolio.

C)   more than 100% of their money invested in the market portfolio.

D)   a larger percentage of their money invested in the market portfolio and have loaned the remaining amount at the risk-free rate.

The correct answer was A)     

Portfolios that are on the CML where the CML touches the efficient frontier implies that 100% of investors funds should be invested in the market portfolio to achieve greatest utility.

13．Investment Management Inc. (IMI) uses the capital market line to make asset allocation recommendations. IMI derives the following forecasts: 

§ Expected return on the market portfolio: 12%

§ Standard deviation on the market portfolio: 20%

§ Risk-free rate: 5%

Samuel Johnson seeks IMI’s advice for a portfolio asset allocation. Johnson informs IMI that he wants the standard deviation of the portfolio to equal one half of the standard deviation for the market portfolio. Using the capital market line, the expected return that IMI can provide subject to Johnson’s risk constraint is closest to:

A)   7.5%.

B)   6.0%.

C)   10%.

D)   8.5%

The correct answer was D)

The equation for the capital market line is:

Johnson requests the portfolio standard deviation to equal one half of the market portfolio standard deviation. The market portfolio standard deviation equals 20 percent. Therefore, Johnson’s portfolio should have a standard deviation equal to 10 percent. The intercept of the capital market line equals the risk free rate (5 percent), and the slope of the capital market line equals the Sharpe ratio for the market portfolio (35 percent). Therefore, using the capital market line, the expected return on Johnson’s portfolio will equal:

14．Portfolio Management Associates (PMA) provides asset allocation advice for pensions. PMA recommends that all their pension clients select an appropriate weighting of the risk-free asset and the market portfolio. PMA should explain to its clients that the market portfolio is selected because the market portfolio:

A)   maximizes return.

B)   maximizes the Sharpe ratio.

C)   minimizes risk.

D)   maximizes return and minimizes risk.

The correct answer was B)

The risk and return coordinate for the market portfolio is the tangency point for the capital market line (CML). The CML has the steepest slope of any possible portfolio combination. The slope of the CML is the Sharpe ratio. Therefore, the Sharpe ratio is highest for the market portfolio.