Question

1. Which of the following regarding the Capital Market Line (CML), is false?
   1. In equilibrium, the CAPM says that the CML represents the best risk-reward combinations available to all investors.
   2. The slope of the CML is the risk premium on the market portfolio divided by its standard deviation.
   3. Although investors will try and achieve higher returns, the forces of competition will move asset prices toward the CML.
   4. The CML applies regardless of market conditions.

Answer 1

D) The CML applies regardless of market conditions.

Reason :

• Capital market line (CML) is a graph that reflects the expected return of a portfolio consisting of all possible proportions between the market portfolio and a risk-free asset. The market portfolio is completely diversified, carries only systematic risk, and its expected return is equal to the expected market return as a whole.

The key problem of capital market line in real markets conditions is that CML is based on the same assumptions as capital asset pricing model CAPM).

• There are taxes and transaction costs, which can significantly differ for various investors.
• Real markets don’t have strong form of efficiency, so investors have unequal to information.
• Not all investors are rational and risk-averse.
• Standard deviation isn’t the only risk measurement, because real markets are subject to inflation risk, reinvestment risk, currency risk etc.
• There are no risk-free assets.