optimal portfolio - optimal risky portfolio

CFA Level I Portfolio Management
#1

Hi,

My question is referring to the chapter 43, PM, question 36 EOC.

I understood that the optimal portfolio is not EQUAL to the optimal RISKY portfolio.

The optimal portfolio is when the CAL is tangent to the highest indifference curve of an investor and each investor has thus a different optimal portfolio.

The optimal risky portfolio is also known as the market portfolio, and it’s when the dominant CAL is tangent to the minimum variance frontier (of course, if I’m wrong, do no hesitate to correct me).

Ok so far, so good.

Now, the question 36 from the curriculum:

With respect to capital market theory, which of the following statements best describes the effect of the homogeneity assumption? Because all investors have the same economic expectations of future cash flows for all assets, investors will invest in:

  1. the same optimal risky portfolio.
  2. the Standard and Poor’s 500 Index.
  3. assets with the same amount of risk.

Correct answer is A with the followin explanation:A is correct. The homogeneity assumption refers to all investors having the same economic expectation of future cash flows. If all investors have the same expectations, then all investors should invest in the same optimal risky portfolio, therefore implying the existence of only one optimal portfolio (i.e., the market portfolio).

I was wondering if there was a wording mistake. Shouldn’t it be written only one optimal RISKY portfolio?

Plus, I don’t really understand the difference between the indifference curve and the utility curve. I always have the feeling that it’s the same!

By the way, I am the only one to find the chapter 43 one of the most challening in the curriculum?

Some help is appreciated.

#2

anyone :frowning: ?

#3

In CML there is only one optimal portfolio. Doesnt matter what you call it. Consider the literal meaning of optimum portfolio.

#4

Utility and indifference curves are the same. Matter of wording. I agree with Gigaloo above

#5

How you build the efficient frontier of risky assets? You get the whole universe of risky assets currently trading and select the ones with the highest return due a given level of risk. Risk advances to the right and return advances upwards, there you get the efficient frontier.

The CML starts at the risk-free rate level and is tangent to the efficient frontier, there you create an optimal risky portfolio. It is an optimal risky portfolio because it contains the assets with the best mean and variance of returns relation of all risky assets available in the market (like individual sharpes).

Due the risk aversion, investors don’t commonly invest all their money in the optimal risky portfolio. So depending on their indifference curves which plot the risk-free asset and the optimal risky portoflio, they will invest a x% of their money in the risk-free asset and a (1-x%) in the risky portoflio. This last portfolio is called the optimal portfolio because it borns from the maximization of the utility curve of the investor (the utility curve considers risk aversion, risk and return).

Knowing this, if all investors have the same expectations about all assets on the market (homogeneous expectations), their models will include exactly the same assets, all classified exactly the same way and all they will have the same optimal risky portfolio.

Hope this helps.

1 Like
#6

thank you all!

#7

thank you all!