- CFA Exams
- CFA Level I Exam
- Study Session 18. Portfolio Management (1)
- Reading 53. Portfolio Risk and Return: Part II
- Subject 4. Applications of the CAPM

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**CFA Practice Question**

Which of the following is (are) true about the Capital Market Theory?

II. The correlation between two portfolios on the SML equals +1.

III. Portfolios that lie on the Capital Market Line (CML) are as completely diversified as possible.

IV. Portfolios that lie on the SML are not necessarily completely diversified.

I. A portfolio that lies above the Security Market Line (SML) is underpriced.

II. The correlation between two portfolios on the SML equals +1.

III. Portfolios that lie on the Capital Market Line (CML) are as completely diversified as possible.

IV. Portfolios that lie on the SML are not necessarily completely diversified.

A. I, III and IV

B. I, II, III and IV

C. I, II and IV

**Explanation:**The Capital Market Line is a combination of the risk-free asset and the tangency portfolio that lies on the efficient frontier of risky assets. Hence, the CML consists entirely of efficient portfolios (and every single efficient portfolio must lie on the CML). Furthermore, all the portfolios that lie on the CML are perfectly positively correlated. The SML, on the other hand, plots the expected return of a security against its beta. CAPM then implies that the SML is a straight line with the intercept representing the risk-free rate. Every single investment security that is fairly priced must lie on the SML. Thus, not every portfolio that lies on the SML is an efficient portfolio or completely diversified.

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**User Contributed Comments**
5

User |
Comment |
---|---|

Shelton |
true I, wrong II => A |

volkovv |
Good question. Statement II fooled me, and I got it wrong. The correlation between two portfolios on CML equals to +1! but that is not true for SML. |

steved333 |
Well put, I made the same mistake! |

Poorvi |
ditto! |

kplatis |
good question.. |