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Which of the following statements are (is) correct with respect to the Capital Allocation Line (CAL):a. graphical depiction showing possible combinations of risk free and risky assetsb. assumes a linear r/ship between risk and returnc. Slope = Sharpe Ratiod. Helps investors determine an asset mix most suitable for theme. All of the above

Question

Which of the following statements are (is) correct with respect to the Capital Allocation Line (CAL):a. graphical depiction showing possible combinations of risk free and risky assetsb. assumes a linear r/ship between risk and returnc. Slope = Sharpe Ratiod. Helps investors determine an asset mix most suitable for theme. All of the above

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Solution

The correct answer is:

e. All of the above

Here are the steps to explain this:

  1. Graphical Depiction: The Capital Allocation Line (CAL) is a line that illustrates the risk and return trade-off for a specific portfolio, in combination with a risk-free asset. The x-axis represents risk (usually standard deviation of the portfolio's returns) and the y-axis represents expected return. The points along the line represent different combinations of the risk-free asset and the risky portfolio.

  2. Linear Relationship: The CAL assumes a linear relationship between risk and return. This means that as risk (standard deviation) increases, the expected return of the portfolio also increases linearly.

  3. Slope = Sharpe Ratio: The slope of the CAL at any point is equal to the Sharpe Ratio of the portfolio at that point. The Sharpe Ratio is a measure of risk-adjusted return, calculated as the excess return of the portfolio over the risk-free rate divided by the standard deviation of the portfolio's return.

  4. Helps Investors Determine Asset Mix: By looking at the CAL, investors can determine the mix of the risk-free asset and the risky portfolio that will provide them with the highest expected return for a given level of risk.

So, all of the statements a, b, c, and d about the Capital Allocation Line (CAL) are correct.

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