Ch 6

Notes 4A
Ch 7

Notes 4B
Ch 6
Road Map to Asset Allocation

2
 s
2
MaxU = E (
y r c
) - .5 A
c

ys
2 2
= r f
+ y[ E ( r p
)- r f
] - .5 A
p

And setting this to zero, and solve for y

s
2
E( r p
)- r f
- Ay
p
=0

y
*
=
E( r p
)- r f

s
2
A
p

3
 Notes 4B
Portfolio Theory II: Capital Allocation
Learning Objectives
• Define capital allocation line (CAL).
• Explain how the optimal mix of a risky and risk-free asset is
determined for a risk- averse investor and illustrate it with a
graph, with or without borrowing.
• Calculate the expected return and risk for a portfolio on the
CAL
• Explain the separation property/theorem.
• Calculate the optimal investment in the risky portfolio (y)
and risk-free asset (1-y).
• Explain how a capital market line (CML) is derived.
• Discuss the relationship between CAL and CML.
• Compute and interpret the reward-to-variability ratio.

4
 Recap from Notes 4A
• Previously, we have learned how to obtain the optimal risky
portfolio for an individual investor from the efficient frontier
(a segment of the Minimum-variance (MV) frontier) in a
capital market where there are no risk-free assets, i.e., no
borrowing or lending at the risk-free rate.
• The efficient frontier is the investor’s investment opportunity
set for risky assets, comprising numerous efficient portfolios
at different levels of expected return.
• Now, let’s assume the capital market has risk-free assets.
How do we determine the optimal risky portfolio for an
individual investor given her utility function/risk tolerance
function?

5
 I. Capital Allocation:
Asset Allocation with a Risky Asset (a portfolio) and a Risk-
Free Asset (a portfolio)
• By combining a risk-free asset (a portfolio of various risk-free assets)
to an efficient, risky portfolio on the efficient frontier, investors
expand the investment opportunity set from the efficient frontier to
Capital Allocation Line (CAL)
– i.e., Investors are able to use leverage (e.g., buying on margin, or
borrowing a loan to buy stocks) to amplify the return on the
upside with possible larger losses on the downside.
• In the following section, we first show that a linear combination of an
efficient, risky portfolio (e.g., P, P1, or P2) and a portfolio of risk-free
assets yield a new investment opportunity set, such as CAL, CAL1,
and CAL2. (see graph below) dominates the efficient frontier.
• Then we demonstrate how the optimal risky portfolio, P, is identified.
• Finally, we show how the optimal complete portfolio for a particular
investor is determined.

6
• Combining an efficient risky portfolio (P, P1, P2) with a risk-free
asset, rf, (both lending & borrowing allowed at risk-free rate)
yields a new investment opportunity set, known as the Capital
Allocation Line
CALP
E(r)

CAL1

P CAL2

P1

P2
rf
Std.
Dev

• Let’s begin with the concept of capital allocation

7
 I. Capital Allocation
• Capital allocation is to decide how we optimally
allocate investment capital, i.e., optimally split the
capital between a risky asset and a risk-free asset

• Suppose our total investment capital is $1 or 100%;

there are risky and risk-free (safe) assets

• Assume we want to maximize investor’s utility in

terms of risk-return tradeoff

• We need to determine how we split investment

funds ($1 or 100%) between safe (risk-free) and
risky assets.
Risk-free assets: proxy is a portfolio of T-bills
Risky assets: a stock (or a portfolio)

8
 I. Capital Allocation
• How? The approach is:
1. Consider the risk/return tradeoff of the two
assets.
2. Determine how different degrees of risk aversion
affect allocation between risky and risk-free
assets

• What are the tradeoffs available to investor? i.e.,

what are the expected return and risk for different
allocations? Say, 100% in risk-free assets? 100% in
risky assets? 75% risky/25% risk-free?

• Note: Investing in risk-free assets is analogous to

lending at the risk-free interest rate.
9
Graphing possible combinations to delineate
the Capital Allocation Line (CAL)
E(r)

P
100% in the portfolio comprising
only risky assets, e.g., stocks
and bonds
C
CAL Portfolio consisting of
75% P and 25% rf

rf
100% in a portfolio of risk-free assets

Std.
Dev

10
 I. Capital Allocation
• Let y = % of funds invested in risky portfolio, P
rp = return of risky portfolio
rf = risk-free return
rc = return of complete or combined portfolio

E (r c ) = y ´ E (r p ) + (1 - y ) ´ r f

E (r c ) = r f + y[ E (r p ) - r f ] (Eq. 6.8)
6.3)

11
 Example using the numbers in Ch6.4
rf = 7% srf = 0% E(rp) = 15%
sp = 22% y = % in P (1-y) = % in rf

E(rc) = expected return of the complete portfolio

or combined portfolio
E(rc) = y E(rp) + (1 - y) rf

y E(rc) sp
100% 15% 22%
0% 7% 0%
12
 A. Capital Allocation Line (CAL)
(No leverage = No borrowing at risk-free rate)
E(r)

CAL
P
E(rp) = 15%

E(rp) - rf = 8%
) S = .08/.22 = .36
7% = rf

s
0 sp = 22%
13
 A. Capital Allocation Line (CAL)
The slope of CAL, which is a straight line, is measured by its:

!"#$ [( )! *)" ]
Slope = = = Reward-to-Variability Ratio
!%& ,!

= (.15-.07)/.22
= .36

• The rise is the risk premium, 𝐸 𝑟! − 𝑟" , of the risky

portfolio
• The run is the (total) risk, 𝜎! , of the risky portfolio

14
 Example using the numbers in Ch6.4,
y = .75

E(rc) = .75 (.15) + .25 (.07)

= .13 or 13%
How do we compute variance for possible
combinations?
Since s r = 0, then
f

sc = y sp Portfolio Math Rule #5 in Notes 3B

Thus, sc = .75 (.22) = .165

 A. Capital Allocation Line (CAL)
with no borrowing at risk-free rate
E(r)
C has 75% in P (y =.75) and 25% (1-y=.25) in rf

P
E(rp) = 15%
E(rc) = 13%
C

rf = 7% F

sc s
0 22%
16.5%
16
Investment Opportunity Set (CAL) with No
Borrowing (only lending or investing in risk-free
asset is available)
MV frontier
E(r) CALP

Portfolio containing
C only risky assets, e.g.,
stocks and bonds
Portfolio containing P and
rf risk-free asset (i.e., lending at risk free rate)

Std.
Dev
17
 A. Capital Allocation Line
E( r ) = y ´ E (r
c p
) + (1 - y ) ´ r f

E( r )=r
c f
+ y[ E ( r p
)- r f
] 6.3)
(Eq. 6.4)

Since s c
=y s p
(Portfolio Math #5) (Eq. 6.4)

E( r )=
s
r s + c
[E( r )- r ] (Eq.6.10)
c f p f
p

[E( r )- r ]
s
p f
E( r )=r
c f
+
s c (Eq. 6.3-4)
p

Our Eq. 6.3-4 is an equation for a straight line, known as the CAL that
depicts all the risk-return combinations available to investors, given P and rf ,
where rf is the intercept of the straight line, CAL.
18
 Combinations Without Leverage
Using Eq. 6.4 and Eq. 6.3-4
y sc = y (.22) E(rc) = .07 + (.08/.22) sc
1 .22 .15
.75 .165 .13*
0 0 .07

*Question:
Is there another way of computing E(rc) without using
E(rc) = .07 + (.08/.22) sc ?

E(rc) = y x 15% +(1-y) x 7%

= 0.75 (.15)+0.25 (.07) = .13

Assigned Problems:
Chapter 6 #13-18
19
 Assigned Problems Ch6
For #13-19: You manage a risky portfolio with
expected rate of return of 18% and standard
deviation of 28%. The T-bill rate is 8%.
• #13: Your client chooses to invest 70% in your risky
fund and 30% in T-bill money fund. What are the
expected return and std. deviation of your client’s
portfolio?
• Answer:
Expected return =
Standard deviation =

20
 Ch. 6 #14
• Question: Suppose that your risky portfolio includes
the following investments in the given proportions:
Stock A 25%, Stock B 32%, and Stock C 43%. What
are the investment proportions of your client’s
overall portfolio, including the positions in T-bills?
• Answer: 30.0% in T-bills therefore 70% in stocks
0.7 ´ 25% = _____% in Stock A
0.7 ´ 32% = _____% in Stock B
0.7 ´ 43% = _____% in Stock C

21
 Ch. 6 #15
Question: What is the reward to variability ratio
(s) of your risky portfolio? Your client’s?
Answer:
• Your reward-to-variability ratio:
S=

• Client's reward-to-variability ratio:

S=

22
 Ch. 6 #16
Question: Draw the CAL of your portfolio. What is the
slope of the CAL? Show the position of your client’s
portfolio on your fund’s CAL.
30
Does not extend
CAL (Slope = 0.3571)
beyond P to the
25
right if borrowing
20 is not allowed at
E(r)%
15 P the risk-free rate;
Client
the problem does
10
not specify
5

0
0 10 20 30 40

s (%)

23
 Ch. 6 #17a.
Question:
Suppose that your client decides to invest in your portfolio a
proportion y of the total investment budget so that the overall
portfolio will have an expected rate of return of 16%. What is
the proportion of y?
Answer:
E(rC) = rf + y[E(rP) – rf] = .08 + y(.18 - .08)
If the expected return for the portfolio is 16%, then:
.16 = .08 + .10 y Þ y = .16 −.08 = 0.8
.10
Therefore, in order to have a portfolio with expected rate of return
equal to 16%, the client must invest 80% of total funds in the
risky portfolio and 20% in T-bills.
24
 Ch. 6 #17b.
Question: What are your client’s investment
proportions in your three stocks and the T-bill
fund?
Answer: Client’s investment proportions:
20.0% in T-bills and 80% in stocks
0.8 ´ 25% = _____% in Stock A
0.8 ´ 32% = _____% in Stock B
0.8 ´ 43% = _____% in Stock C

25
 Ch. 6 #17c.
Question: What is the standard deviation
of the rate of return on your client’s
portfolio?

sC = 0.8 ´ sP =

26
 Ch. 6 #18
Question: Suppose that your client prefers to invest in your fund
a proportion, y that maximizes the expected return on the
complete portfolio subject to the constraint that the
complete portfolio’s standard deviation will not exceed 18%.
a. What is the investment proportion, y?
Answer: sC = y ´ 28%
Since if your client prefers a standard deviation of at most 18%, then:

y= = _____ % invested in the risky portfolio

b. What is the expected rate of return on the complete portfolio?

Answer:
E(rC) = .08 + .1y
=

27
 B. Capital Allocation With Leverage
(i) Borrowing at the Risk-Free Rate (7%)
E(r)
CAL
L
E(rL) = 19%
P
E(rp) = 15%
E(rL) -rf = 12%

F ) S = .12/.33=.36
rf = 7%

s
0 sp = 22% 33%
28
 B. Capital Allocation With Leverage
(ii) Borrowing at Higher Risk-Free Rate (9%)

!"#$
RTV= (.15-.09)/.22 = .27

CAL with higher borrowing rate, kinked at P

P
) S = .27
E(rp)=15%
)
9%
) S = .36
7%

s
s p = 22%
29
 C. Dominant CAL
• When we combine an efficient, risky portfolio (P, P1, or P2) with a risk-
free asset, rf, (both lending & borrowing allowed at risk-free rate), a
CAL is formed (CALP, CAL1, and CAL2).
CALP
E(r)

CAL1

P CAL2

P1

P2
rf

Std.
Dev 30
 C. Dominant CAL
• In the above graph, CALP dominates other CALs (CAL1 and CAL2)
since it has the best risk/return tradeoff or the greatest slope
• Slope of CAL = Rise/Run = (E(r) - rf) / s
[ E(rP) - rf) / s P ] > [E(rP1) - rf) / s P1] > [ E(rP2) - rf) / s P2 ]
RTV of CALP > RTV of CAL1 > RTV of CAL2
• The highest CALP, which touches the minimum variance frontier at
P, maximizes the slope or the reward-to-variability (RTV)/
Sharpe ratio.
• All portfolios lying on CALp dominate portfolios lying below on
CAL1 and CAL2; they are more efficient in terms of RTV.
• For example, in the next graph, B has higher return than Q for the
same level of risk, hence greater RTV ratio; same as A is better
than D. (See graph, p.31)
• CALp becomes the new investment opportunity set, replacing the
efficient frontier.
• P is the optimal risky portfolio for all investors, regardless of
their degree of risk aversion.
31
• Portfolios on CALP (with lending & borrowing at
risk-free rate) (e.g., B & A) are better than those
(e.g., Q & D) on the efficient frontier
E(r)
CALP
B

Q
A P

rf

Std.
Dev 32
Optimal Risky Portfolio with a Risk-free asset
(i.e., Lending & Borrowing allowed)

CALP
E(r)

rf

Std.
Dev 33
 Investment Opportunity Set (CAL)
with Borrowing
CALP
E(r)

Portfolio containing
only risky assets, e.g.,
C stocks and bonds
* E(r p ) − r f
y =
Aσ
2
p

?%=rf

Std.
Dev
34
 Investment Opportunity Set (CAL)
with Borrowing
MV frontier
CALP
E(r)

Portfolio containing
only risky assets, e.g.,
C stocks and bonds

rf

Std.
Dev
35
 D. (i) Determining Optimal Risky Portfolio (P)
The case of 2 risky assets + a risk-free asset
• How do we determine the composition of P (i.e., the optimal %
invested in E (Stocks) and % in D (Bonds) when there is a risk-free asset,
i.e., borrowing and lending at the risk-free rate?)
E(r p ) − r f
Objective: MaxS =
σ p

with respect to Wi subject to sum of WS + WD =1

2
[E(rD )−rf ]× σ −[E(rE )−rf ]×Cov(rD ,rE )
E
wD =
[E(rD )−rf ]× σ E2 +[E(rE )−rf ]× σ D2 −[E(rD )−rf + E(rE )−rf ]×Cov(rD ,rE )
WE = 1- WD Equation 7.13 on p. 213

36
Assigned Problems Ch 7 #6-8

37
Ch 7 #6. Draw a tangent from the risk-free rate to the opportunity
set. What does your graph show for the expected return and
standard deviation of the optimal portfolio?
6. The graph indicates that the optimal portfolio is the tangency portfolio with
expected return approximately 15.6% and standard deviation approximately
16.5%.

25.00

INVESTMENT OPPORTUNITY SET

20.00 CAL
CML

Tangency
Portfolio Efficient frontier
15.00 of risky assets

10.00 Minimum
rf = 8.00 Variance
Portfolio

5.00

0.00
0.00 5.00 10.00 15.00 20.00 25.00 30.00
7. Solve numerically for the proportions of each asset and for
the expected return and standard deviation of the optimal risky
portfolio. (Note: 2 risky assets, a risk-free asset available: Use Eq.
7.13 on p. 213)
7. The proportion of the optimal risky portfolio invested in the stock fund is given by:
[ E (rS ) - rf ] ´ s B2 - [ E (rB ) - rf ] ´ Cov(rS , rB )
wS =
[ E (rS ) - rf ] ´ s B2 + [ E (rB ) - rf ] ´ s S2 - [ E (rS ) - rf + E (rB ) - rf ] ´ Cov(rS , rB )

wB =

The mean and standard deviation of the optimal risky portfolio are:
E(rP) = (_______ × .20) + (_______ × .12)
= __________%
σp = [(0.45162 ´ 900) + (0.54842 ´ 225) + (2 ´ 0.4516 ´ 0.5484 × 45)]1/2
= ___________%
8. What is the Sharpe ratio of the best feasible CAL?

The reward-to-volatility ratio of the optimal CAL is:

!"($!) − $" '
=
(!
 D. (ii) Finding Optimal Risky Portfolio, P,
on the Efficient Frontier when there are more than
2-Risky Assets and a Risk-Free Asset
Objective E(r p ) − r f
Maximizeθ =
Function σ p

Subject to
Constraints n

∑w = 1 i
i=1

w i
≥ 0 for all i

• P is the optimal risky portfolio (the most efficient combination of certain

risky assets that comprise the efficient frontier) for all investors, regardless
of their degree of risk aversion.
Note: To solve this mathematically, we apply quadratic programming (such
as using the Solver in Excel). This is what we do in the term project, the
same set-up for Solver used in Kwan’s article.
41
 Summary for Part I
Now, we have established the following:
• The presence of risk-free assets in the market enables investors to
invest (lend) or borrow at the risk-free rate. Some investors may
have to borrow at a higher interest rate.
• Combining the risk-free assets with an efficient risky portfolio on the
efficient frontier yield a new investment opportunity set (the CAL).
• The CAL with the greatest slope that touches the efficient frontier is
the best attainable investment opportunity set for investors in a
capital market where there are numerous risky assets and risk-free
assets. Portfolios on the CALP dominate all other portfolios available
in the same market.
• Given the risk-free rate, the optimal risky portfolio (P) is located at
the tangency point of CALP and the efficient frontier.
• CALP has the greatest and the same RTV or Sharpe ratio, i.e., the
greatest reward per unit of risk (measured by the standard deviation)
for all portfolios on CALP.
42
 II. Risk Tolerance and Asset Allocation
• Now with P determined, investors need to determine the split of their
capital investment between the optimal risky portfolio (P) and the
risk-free asset portfolio, which depends on how much investors want
to put their money at risk.
• If the investor is risk-averse, she would put less in P (the optimal
risky portfolio), and invest more in the risk-free assets (i.e., lend
money at the risk-free rate to others).
• If the investor is less risk-averse, or more risk-tolerant, she would
allocate more capital to risky assets (P) and even borrow money (at
the risk-free rate or higher) to increase the bet in the risky portfolio,
P.
• Willingness to accept high levels of risk for high levels of returns
would result in leveraged combinations.
• Given the utility function
U = E (r) - .5 A s2

• Question: How investor chooses her own optimal portfolio (the

complete portfolio, C)? 43
II.A. Determination of Optimal Complete Portfolio,C.

(1) Graphically, the optimal complete portfolio

(capital allocation) is determined by
(i) delineating the CAL; and
(ii) finding the tangency point of the higher
indifference curve to the CAL.
(Figure 6.7)

44
Figure 6.7 Finding the Optimal Complete
Portfolio Using Indifference Curves

45
 Table 6.6 Expected Returns on Four
Indifference Curves and the CAL, A=4

46
 II.A.(1) (i) CAL with no borrowing
(only lending or investing in risk-free asset is available)
MV frontier
E(r) CALP
U3 U2
U1
P

Optimal Risky Portfolio, P,

containing only risky assets,
CL e.g., stocks and bonds

Complete portfolio, CL, containing P and

rf risk-free asset (i.e., lending/investing
at risk-free rate) for a risk-averse investor

Std.
Dev
47
 II.A.(1) (ii) CAL with borrowing and lending
at risk-free rate

E(r) U3U2
U1 CALP

CB
Complete portfolio, CB,
containing a leveraged P and
borrowing at risk-free rate for
P a more risk-tolerance investor

CL

?%=rf

Std.
Dev 48
II.A.(1) Capital allocation per risk preference
• Individual investors with different degrees of risk tolerance
face the same investment opportunity set (a risk-free rate
and a reward-to-variability ratio) will choose different
allocations to risky assets.
• The more risk-averse, the lower risk tolerant, the less their
investment in risky assets and more in the risk-free asset
(combinations on the CAL to the left of P), e.g., CL
• The less risk-averse or higher risk-tolerant, the greater the
investment in risky assets (i.e., leveraged position in P, and
to the right of P), e.g., CB
• CB would have >100% investment in P and a negative % in
risk free asset (i.e., borrowing at the risk-free rate)

49
 II.A.(1) Capital allocation per risk preference
U3
U2
U1 CALP

E(r)
CB
U1
P

CL

?%=rf

Std.
50
Dev
II.A.(1) CAL with Two Different Risk Preferences
The lender has higher risk aversion than the borrower
U3
U2
Borrower U1
E(r) Lender
U3 CALP
U2
U1
CB
P

7% CL

s
s p = 22%
51
II.A. (1) CAL with Two Different Risk Preferences
How CL and CB are determined, given investor’s utility function?
What is % of P + % of rf in CL and in CB
U3
U2
U1
E(r) Lender Borrower
U3
U2 CALP
U1
CB

CL
7%

s
The lender has a larger risk aversion index (A)
52
when compared to the borrower
II.A.(2) Determination of Optimal Complete Portfolio
(Two-asset case: A portfolio of Risky assets and a portfolio of Risk-free assets)
(2) Mathematically, maximizing the utility with respect to y, which is the % of
investment capital allocated to risky portfolio, P, and setting it to zero and solve
for y. From Notes 3B, U = E(r) - .5As2 where A is an index of investor’s risk
aversion. (Note: Inputs to the utility equation must be in in decimal.)

Max U = E (r c ) - .5 As c = r f + y[ E (r p ) - r f ] - .5 A y s
2 2 2

y p

And setting this to zero, and solve for y

E (r p ) - r f - Ay s p = 0
2

* E (r p ) - r f
y =
As p
2

53
II.A.(2) Determination of Optimal Complete Portfolio
(Two-asset case: A portfolio of Risky assets and a portfolio of Risk-free assets)

* E(r p ) − r f
y =
Aσ
2
p

where y* = optimal allocation (weight) to the portfolio, P, of risky assets

The optimal position in the risky asset portfolio, P, is

1. Inversely proportional to the level of risk aversion, A, and the level
of risk (as measured by the variance, 𝜎!" );
2. Directly proportional to the risk premium, [E(rp) – rf], offered by the
risky asset.

54
 Example 6.4 Capital Allocation
rf=2% E(rp) = 10% 𝞼p = 22% A=4

∗
.10 − .02
𝑦 = "
= .41
4 × .22

E(rc) = .02 +[.41 x (.1-.02)] = .0528 = 5.28%

𝞼c= .41 x .22 = .0902 = 9.02%

.0528 − .02
𝑅𝑇𝑉 = = .36
.0902
(Note: Assigned Problem Ch 6 #19)
55
 Assigned Problem Ch 6 #19
You manage a risky portfolio with expected rate of return of 18%
and standard deviation of 28%. The T-bill rate is 8%. Your
client’s degree of risk aversion is A=3.5
a. What proportion, y, of the total investment
should be invested in your fund?
(()% )*)&
𝑦∗ = =
0,%'
Therefore, the client’s optimal proportions are: _____%
invested in the risky portfolio and ______% invested in T-
bills.

56
 Ch 6 #19
b. Question: What is the expected value and
standard deviation of the rate of return on
your client’s optimized portfolio?
Answer:
E(rC) = .08 + .1y*
=
sC =

57
• The individual optimal complete portfolio, C, is a linear combination
of the optimal risky portfolio (P) and T-bills (i.e., the CAL, which is
the new, expanded investment opportunity set for those who can
take leverage)
• The optimal complete portfolio depends on the investor’s risk
aversion/risk tolerance.
• For more risk-averse investors they would invest in T-bills (lends at
the risk-free rate) and invest the rest in P; for less risk-averse
investors, they would borrow at the risk-free rate (or higher) and
invest all in the risky portfolio, P.
• Both will use P managed by professional portfolio managers, since
it gives the greatest reward-to-variability ratio, and how much to
invest in P depends on how much leverage each type of investors
wants to use is personal. (Separation Property)
• In practice, P varies because
(1) managers have different inputs to forecasting and stock
selection;
(2) portfolio constraints e.g., holdings limit, dividend requirements,
tax considerations, and other personal preferences
58
Determination of the Optimal Overall Portfolio
(Complete Portfolio, CL)
• Using Example 6.4 numbers (similar to Fig 7.8)

E(r) %
Utility/indifference curves Investment opportunity set
U2 U1 CALP

P MV frontier
15

10.28 Optimal Risky Portfolio

CL
7
Optimal Complete
Portfolio, CL

s%
s L=9.02 s p=22
* E(r p ) − r f
y =
Aσ
2
p
59
 Summary of Asset Allocation
(see above graph or Fig. 7.8 )
Practical Steps to arrive at the complete portfolio:
1. Specify the return characteristics of all securities/assets (expected
returns, variances, covariances) to delineate the efficient frontier
2. Establish the optimal risky portfolio
a. Determine the optimal risky portfolio, P (Use Eq. 7.13
because two risky assets in here; if more than 2 risky assets,
use QP algorithm, e.g., Solver)
b. Calculate the risk-return properties of Portfolio P using the
weights determined in step (a) and Eq 7.2 and 7.3
3. Allocate funds between the risky and risk-free asset (i.e., Capital
Allocation):
– a. Calculate the fraction of the complete portfolio allocated to
Portfolio P, the [optimal] risky portfolio, (i.e., y*) and to T-bills,
the risk-free asset, (i.e., 1-y*) (Equation 7.14)
– b. Calculate the share of the complete portfolio invested in each
asset and in T-bills.

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III. Passive Strategies: The Capital Market Line
• Portfolio theory posits that an individual investor maximizes her utility by
finding the optimal risky portfolio and combining it with the appropriate %
in the risk-free asset to obtain her optimal complete portfolio.
• If she hires an asset manager who builds the optimal risky portfolio, P, for
her, she only has to decide how much she wants to invest in the risk-free
asset or how much she wants to borrow. This is a financing decision,
making this possible to separate from the investment decision (i.e.,
construct the optimal risky portfolio, P) due to the separation property of
CAL.
• Thus, the CAL represents a passive strategy that avoid any direct or
indirect security analysis in the risky asset portfolio under portfolio theory.
• Under certain assumptions, investors facing the same market conditions
would face the same investment opportunity set (i.e., same CAL), the
CAL becomes the Capital Market Line (CML).
• The CML is a combination of T-bills and a market portfolio proxy, e.g.,
S&P 500 (this is the optimal risky portfolio, P).
• Advantages of passive strategy
1. Lower costs – lower transaction costs; no need for information and
analysis
2. Free rider benefits – all securities are fairly priced in a well-diversified
market portfolio
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