Question

(b) Consider the following graph: CAL(P) E(R) Indifference curve Efficient frontier of risky assets Optimal risky portfolio Expected return (%) Standard deviation (%)

1. ) What does the indifference curve represent?

2. ii) What is CAL(P)?

3. iii) What is the efficient frontier of risky assets?

4. iv) Explain what the point C represents.

5. v) How can an investor access pointK?

(c) Outline and discuss three limitations of the CAPM.

Answer 1

i ) the indifference curve represents various combinations od risk and return on which the investor is equally happy.

ii) The CAL (P) is a straight line that passed from the risk free rate and makes tangency with efficient frontier and represents the best possible sets of risk and return.

iii) The efficient Frontier is risk assets represent the efficient combinations of risky assets which give the highest expected return for all possible portfolios at same risk

iv ) point c represent the optimal combinations of risk and return

v) investors can access point k by borrowing.

Vi) limitations of CAPM -

a) inability to borrow and lend at the risk free rate which is an assumption and not possible to follow in real life

b) not possible to estimate beta of a project and different substitues are used for that

c) Investors have homogeneous expectations of risk and return is an assumption which is not true in real life