1. Capital Market Theory
a. describe the implications of combining a risk-free asset with a portfolio of risky assets;
b. explain the capital allocation line (CAL) and the capital market line (CML);
What are the three characteristics of a risk-free asset?
1. Expected return is entirely certain.
2. Standard deviation of return is zero.
3. Covariance with any risky asset or portfolio is always zero, as is the correlation.
What is a capital allocation line?
The capital allocation line (CAL) is the graph of all possible combinations of the risk-free asset and the risky asset for one investor.
How does a strongly risk-averse investor versus a less risk-averse investor handle risk in their choice of market portfolio?
- A strongly risk-averse investor will lend some funds at the risk-free rate and invest the remainder in the market portfolio.
- A less risk-averse investor will borrow some funds at the risk-free rate and invest all the funds in the market portfolio.
What are Differential Borrowing and Lending Rates?
Most investors can lend unlimited amounts at the risk-free rate by buying government securities, but they must pay a premium relative to the prime rate when borrowing money.
(There are lots of concepts in this one that I don't understand)