Which of the following best describes the Capital Market Line (CML) in the context of investments in securities?

• A. It illustrates the relationship between a security's expected return and its beta with the market.
• B. It shows the efficient frontier of all risky assets without including the risk-free asset.
• C. It is a graphical representation of the time value of money.
• D. It represents the set of portfolios that optimally combine risk-free assets and the market portfolio, showing the highest expected return for a given level of risk.

Answer: (D)

Verified step by step guidance

1. Understand the concept of the Capital Market Line (CML): The CML is a graphical representation in portfolio theory that shows the relationship between risk (standard deviation) and expected return for portfolios that combine a risk-free asset and the market portfolio.
2. Recognize the components of the CML: The CML includes the risk-free rate (a fixed return with no risk) and the market portfolio (a portfolio of all risky assets in the market). It represents the optimal risk-return trade-off.
3. Identify the formula for the CML: The equation for the CML is given as: \( E(R_p) = R_f + \frac{E(R_m) - R_f}{\sigma_m} \cdot \sigma_p \), where \( E(R_p) \) is the expected return of the portfolio, \( R_f \) is the risk-free rate, \( E(R_m) \) is the expected return of the market portfolio, \( \sigma_m \) is the standard deviation of the market portfolio, and \( \sigma_p \) is the standard deviation of the portfolio.
4. Compare the CML to other concepts: The CML differs from the Security Market Line (SML), which relates a security's expected return to its beta (systematic risk). The CML focuses on total risk (standard deviation) rather than beta.
5. Conclude the correct description: The CML represents the set of portfolios that optimally combine risk-free assets and the market portfolio, showing the highest expected return for a given level of risk. This aligns with the correct answer provided in the problem.