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CFA Level I · CFA Level I Exam

Portfolio Risk and Return: Part II for CFA Level I

Portfolio Risk and Return: Part II covers how investors combine a risk-free asset with the market portfolio, how systematic risk is priced, and how to judge performance. You solve it by knowing the CAL, CML, CAPM and SML formulas, then applying beta and risk-adjusted ratios to the numbers in the stem.

What this chapter covers

This chapter builds on Part I, where you learned expected return, variance, covariance and diversification. Part II asks a bigger question: if investors can diversify, which risk does the market actually pay for? The answer is systematic risk, measured by beta, and priced through the Capital Asset Pricing Model (CAPM).

You start with the capital allocation line (CAL), which shows the risk-return trade-off from mixing a risk-free asset with a risky portfolio. You then move to the capital market line (CML), where the risky portfolio is the market portfolio. From there you split total risk into systematic and nonsystematic parts, estimate beta with return generating models, and use CAPM and the security market line (SML) to find required return. The chapter ends with risk-adjusted performance measures and the choice of an optimal portfolio for a given investor.

The ideas link to many other topics. Required return from CAPM feeds equity valuation and cost of equity in Corporate Finance. Beta and risk measures return in Portfolio Construction and in Derivatives and Risk Management. Risk-adjusted return ideas are used across portfolio topics. Ethics questions on performance presentation sit nearby too.

Portfolio Construction carries 8-12% weight on the exam. The tools in this chapter also recur across several other topics. The questions are mostly short, formula-driven and predictable, which suits three-option MCQs and a 90-second pace. If you know the formulas and the logic behind them, you can gain marks quickly and also eliminate wrong options on conceptual items. Because there is no penalty for wrong answers, even partial understanding lets you narrow to two options and guess well.

Portfolio Risk and Return: Part II: topics in the order to study them

  1. 1Capital Market Theory and the Capital Allocation LineStart here because the CAL introduces the risk-free asset and the idea of mixing it with a risky portfolio.
  2. 2Capital Market Line and the Market PortfolioThe CML is the CAL with the market portfolio as the risky asset, so it follows directly.
  3. 3Systematic and Nonsystematic RiskYou need to know which risk diversification removes before you learn which risk is priced.
  4. 4Return Generating Models and BetaBeta is the measure of systematic risk, and the models show how it is estimated.
  5. 5Capital Asset Pricing Model and Security Market LineCAPM turns beta into required return, so it needs the previous two topics first.
  6. 6Risk-Adjusted Performance MeasuresSharpe, Treynor, M² and Jensen's alpha use CAPM and CML ideas, so study them after those.
  7. 7Portfolio Selection and Optimal PortfolioThis final topic combines the efficient frontier, the CAL and investor preferences into one decision.

How to prepare Portfolio Risk and Return: Part II

Treat this chapter as a small set of linked formulas. Learn what each one measures, then practise applying it fast.

  1. Read the topics in the order given and write one line per topic on what question it answers.
  2. Build a one-page formula sheet: CAL, CML, beta, CAPM, SML, Sharpe, Treynor, M² and Jensen's alpha. Say what each variable means.
  3. Draw the CML and the SML by hand. Mark the axes: standard deviation for the CML, beta for the SML. Wrong axes are a common source of lost marks.
  4. Practise CAPM and Sharpe calculations on your TI BA II Plus or HP 12C until you can do each in under a minute.
  5. Work conceptual questions on systematic versus nonsystematic risk and on which securities plot above or below the SML.
  6. Do mixed MCQs, and for each one name the two options you can eliminate before choosing.
  7. Revise the formula sheet and diagrams again after two days, then once more in the final week.

Common mistakes in Portfolio Risk and Return: Part II

  • Mixing up the CML and the SML.

    Fix: Remember the axes: the CML uses standard deviation and applies to efficient portfolios; the SML uses beta and applies to any security.

  • Using standard deviation in CAPM instead of beta.

    Fix: CAPM prices only systematic risk, so always use beta for required return.

  • Forgetting to subtract the risk-free rate from the market return.

    Fix: Compute Rm − Rf first, then multiply by beta, then add Rf.

  • Choosing Sharpe or Treynor in the wrong setting.

    Fix: Use Sharpe when total risk matters, such as for an entire portfolio. Use Treynor when the portfolio is one part of a well-diversified holding and beta is relevant.

  • Thinking nonsystematic risk earns a premium.

    Fix: Only systematic risk is compensated, because investors can diversify the rest away at low cost.

  • Misreading whether a security is over- or undervalued from the SML.

    Fix: Compute the CAPM required return first. If expected return is higher, the security plots above the SML and is undervalued.

Last-day revision: Portfolio Risk and Return: Part II

  • CAL: E(Rp) = Rf + [(E(Ri) − Rf) ÷ σi] × σp, where Ri is the risky portfolio. Equivalently, E(Rp) = Rf + w × [E(Ri) − Rf], where w is the weight in the risky portfolio.
  • The CML uses the market portfolio and plots return against total risk (standard deviation).
  • CML slope = [E(Rm) − Rf] ÷ σm.
  • Total risk = systematic risk + nonsystematic risk.
  • Diversification removes nonsystematic risk; systematic risk remains and is priced.
  • Beta = Cov(Ri, Rm) ÷ Var(Rm).
  • CAPM: E(Ri) = Rf + βi × [E(Rm) − Rf].
  • The SML plots required return against beta; the market portfolio has a beta of 1.
  • A security above the SML is undervalued; below it is overvalued.
  • Sharpe ratio = (Rp − Rf) ÷ σp; Treynor ratio = (Rp − Rf) ÷ βp.
  • Jensen's alpha = Rp − [Rf + βp × (Rm − Rf)].
  • M² = Rp* − Rm, where Rp* = Rf + (Sharpe ratio of the portfolio × σm). Equivalently, M² = (Sharpe_p − Sharpe_m) × σm. It is the excess return over the market at equal risk.

Portfolio Risk and Return: Part II practice questions

Portfolio Risk and Return: Part II in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Portfolio Risk and Return: Part II: frequently asked questions

What is the difference between the CAL and the CML?

The CAL shows combinations of the risk-free asset and any risky portfolio. The CML is the CAL through the market (tangency) portfolio. Under CAPM assumptions, it has the highest Sharpe ratio of the available CALs.

Why does CAPM use beta and not total risk?

CAPM assumes investors hold diversified portfolios, so nonsystematic risk is removed. Only the risk that cannot be diversified, measured by beta, earns a premium.

Which formulas should I memorise for this chapter?

Learn the CAL and CML, beta, CAPM, Sharpe ratio, Treynor ratio, Jensen's alpha and M². Know what each measures and which risk it uses. Most questions are direct applications of these.

How do I tell if a stock is overvalued using the SML?

Calculate the required return from CAPM using the stock's beta. If the forecast return is below that, the stock plots below the SML and is overvalued. If it is above, it is undervalued.