a. You hold an efficient portfolio. Which of the CML or the SML gives you the ex

Question

a. You hold an efficient portfolio. Which of the CML or the SML gives you the expected return on your portfolio? What could its composition be?

b. You hold an inefficient portfolio. Which of the CML or the SML gives you the expected return on your portfolio? What could its composition be?

c. Show that any portfolio on the CML is perfectly positively correlated with the market portfolio.

d. Use the answer to the previous question to show that the SML reduces to the CML when an investment is efficient.

Explanation / Answer

a) CML will give the expected return as CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk-free asset in the portfolio. The capital asset pricing model (CAPM) demonstrates that the market portfolio is essentially the efficient frontier.

b) For an inefficient portfolio, SML will give expected return as it is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the investor would be accepting less return for the amount of risk assumed.

c)

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