CFA Practice Question
On the CML, as the portfolio is tilted more towards riskless asset, the expected rate of return falls and approaches the riskless rate. As their increasing weight on the riskless asset continues, there comes a point where the entire portfolio (100%) is invested in the riskless asset. Increasing the portfolio weight on the riskless asset beyond this point:
A. will result in negative beta and an expected return less than the risk-free rate.
B. will be impossible.
C. will result in negative variance and an expected return less than the risk-free rate.
Explanation: It will be negative beta, and will provide insurance against market moves. This insurance (desirable) is the trade-off for expected return lower than the risk-free rate (undesirable). Negative beta is possible (beta is a measure of correlation) but negative variance is impossible.
User Contributed Comments 7
| User | Comment |
|---|---|
| chantal | Beta measures the price (return) volatility of an asset in comparison to the overall market. A negative Beta means that as market returns change, the value of the asset moves in the opposite direction. |
| grew0001 | this is what I think this question means: whereas going beyond CML is borrowing at risk free rate and investing in market, this situation calls for borrowing at market rate and investing in risk free. If the market declines, you get higher returns, and that is how its defensive. That being said, I don't get negative variance and how can you borrow at the market return rate? I still think answer is B. |
| moneyguy | But how can someone increase the portfolio weight of risk-free assets beyond 100%? This is why I chose B. It IS impossible! |
| leftcoast | moneyguy - the same way you increase the portfolio weight beyond 100% in any other situation. Borrowing money to invest. Borrowing at a (most likely) higher rate than the risk free asset would seem counter intuitive, but that doesn't mean it's impossible and could certainly be desirable in the right circumstance. If you had over 100% in the risk free asset before T-Bills went to negative rates in the summer of 2011, you would have done very well for yourself. |
| enetis | perhaps they are referring to SML here? considering the fact that SML is the graph that uses beta whereas CML uses std dev. |
| GBolt93 | I assume this would require shorting the market portfolio and using that money to invest in the RF asset. |
| harrybay | I had the exact same question earlier formulated differently and the answer was that the CML can't go lower than the risk-free rate. |