Question

5. The Capital Market Line and the Security Market Line

In the following table, check whether each statement refers to the Capital Market Line (CML) or to the Security Market Line (SML).

Statement	Capital Market Line (CML)	Security Market Line (SML)
This line defines the linear relationship between the expected return on an efficient portfolio and its standard deviation.
The slope of this line, (r̂Mr̂M – rRFrRF)/σMσM, reflects the investors’ aggregated, or market-level, expected premium for risk.
This line describes the return on an individual security as the sum of the risk-free rate and a premium for the security’s nondiversifiable risk, which is the product of the stock’s beta and the market’s risk premium.

If an investor wants to hold an efficient portfolio that offers an expected return of 12%, should the investor select portfolio A that exhibits a standard deviation of 4% or portfolio C that has a standard deviation of 2%? (Assume that both the portfolios offer an expected return of 12%.)

___The investor should select portfolio C.

___The rational investor will be indifferent about the portfolio selection.

___The investor should select portfolio A.

True or False: Under the assumptions of the CML, the market portfolio’s risk is measured by the standard deviation, whereas the risk component in the SML is measured by the beta coefficient.

False

True

Answer 1