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Lesson 5 of 5 8–12% of the exam

The capital allocation line and the optimal portfolio

Combining a risk-free asset with a risky portfolio gives a straight line, the capital allocation line. The best line touches the efficient frontier at the optimal risky portfolio. Every investor holds that same risky portfolio and picks a point on the line where their highest indifference curve touches it.

6 min cram, 32 min full read. Based on the 2027 CFA® Program Level I curriculum, Portfolio Construction, Learning Module 1. Also part of the 2026 curriculum, so it applies to the November 2026 exam too.

Tailor this to you: take the self-assessment

Before this: The efficient frontier and the global minimum-variance portfolio, Risk aversion, utility and indifference curves

On the exam

  • Explain the selection of an optimal portfolio, given an investor’s utility (or risk aversion) and the capital allocation line
  • Describe and interpret the minimum-variance and efficient frontiers of risky assets and the global minimum-variance portfolio

Explain how an investor’s utility and the capital allocation line together select the optimal portfolio. Expect a CAL return or weight calculation, a utility comparison along the line, and conceptual items on tangency and two-fund separation.

How deeply to learn each part
Know the idea
Understand it in general. It frames other topics, but you will not calculate with it.
Use it
Understand it well enough to solve a question with it. Recognize when it applies.
Memorize
Learn it by heart. The exam will not give it to you.

You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.

You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.

Cram mode: the one-screen version of this lesson. Switch to Full for the explanations, worked examples and interactives.

What happens when a risk-free asset joins a risky portfolio?

A risk-free asset has zero standard deviation and zero correlation with everything else, so it contributes no risk of its own. Put a weight wf in it and the rest in a risky portfolio, and the variance formula collapses: only the risky portfolio’s term survives.

Return and risk with a risk-free asset Memorize
E(Rp)=wfRf+(1−wf) E(Ri),σp=(1−wf) σiE(R_p) = w_f R_f + (1 - w_f)\,E(R_i), \qquad \sigma_p = (1 - w_f)\,\sigma_i

Both equations are linear in the weight, so every mix lies on a straight line from the risk-free rate on the vertical axis through the risky portfolio. That line is the capital allocation line (CAL). Eliminating the weight gives its equation.

Capital allocation line Memorize
E(Rp)=Rf+E(Ri)−Rfσi σpE(R_p) = R_f + \frac{E(R_i) - R_f}{\sigma_i}\,\sigma_p

The intercept is Rf. The slope is the extra return for each extra unit of risk, often called the market price of risk .

Slope of the CAL (market price of risk) Use it
Slope=E(Ri)−Rfσi\text{Slope} = \frac{E(R_i) - R_f}{\sigma_i}
Rearrange itCapital allocation line: solve for the return, the risk, the weight or the slope
The question asks for
The risk-free rate is 3.00%. A risky portfolio has an expected return of 10.00% and a standard deviation of 20.00%. An investor on the capital allocation line who wants a standard deviation of 12.00% will have an expected return closest to:

3 + (10 − 3) ÷ 20 × 12 = 7.20%

Target portfolio expected return7.20%

On your calculator
  1. 10−3=÷20=×12+3=in percent
  1. 10ENTER3−20÷12×3+in percent

ENTER enter (on the HP, puts the number on the stack)

Where a portfolio sits relative to the CAL says everything about it.

Portfolios relative to the capital allocation line
Position against the CALthe line is the set of the best attainable portfolios
  • Above the line Use it desirable but not achievable with the available assets
  • On the line Memorize attainable; the optimal investor portfolio sits here
  • Below the line Use it attainable but dominated: more return is available at the same risk

Which risky portfolio should everyone hold?

With many risky portfolios on the efficient frontier, draw a CAL from the risk-free rate to each of them. A steeper line gives more return for every level of risk, so the best line is the steepest one, which just touches the frontier. The touching point is the optimal risky portfolio : no other line offers more return at the same risk.

That line beats the frontier itself. Take any efficient portfolio X other than the tangency point. A mix of the risk-free asset and the optimal risky portfolio with the same risk as X (lending if X is less risky, borrowing if it is more risky) earns more than X. So the optimal CAL dominates every portfolio of risky assets alone.

Because the choice of risky portfolio does not use anyone’s preferences, every investor who shares the same expectations picks the same one. This is the two-fund separation theorem : all investors hold a combination of two funds, the risk-free asset and the optimal risky portfolio. It splits the problem in two.

Two decisions behind every portfolio
Choosing a portfolio when a risk-free asset existstwo-fund separation: investment decision, then financing decision
  • 1. Investment decision Memorize pick the optimal risky portfolio: where the steepest CAL touches the efficient frontier
    • Same for every investor with the same expectations, whatever the risk aversion or wealth
  • 2. Financing decision Memorize pick the optimal investor portfolio: where the investor’s highest indifference curve touches the CAL
    • Lending below 100% in the risky portfolio; more risk averse
    • Borrowing above 100% in the risky portfolio, borrowed at Rf; less risk averse

Which point on the line is best for you?

The second step brings back the indifference curves from the utility lesson. The optimal investor portfolio is where an investor’s highest reachable indifference curve is tangent to the CAL. A higher curve lies out of reach, above the line; a lower curve, crossing the line, gives less utility. More risk-averse investors end up closer to the risk-free asset; less risk-averse investors sit further out and may borrow. These lending and borrowing portfolios differ only in how much of the same risky portfolio they hold.

InteractiveWhich risky portfolio, and how much of it?

Try this 0 of 3

  • With Rf at 3%, slide to 140% in the risky portfolio and read off E(Rp) and σp
  • Pivot the line flatter until it cuts through the frontier
  • Cut Rf to 1% and pivot the line until it touches the frontier again
  • Efficient frontier
  • Dominated half
  • CAL
0%5%10%15%0%10%20%30%Risk, σ (%)Expected return (%)GMVdominatedCALRf 3.0%Optimal risky

The efficient frontier's lowest-risk mix has risk 13.09% and return 6.00%; mixes below it are dominated. The CAL starts at the risk-free rate of 3.00% and touches the frontier at risk 20.00%, return 10.00%. The chosen position has 60.0% in the risky portfolio: return 7.20%, risk 12.00%.

Minimum-variance mixσ 13.09%, E 6.00%
CAL slope (Sharpe ratio)0.350
In the risky portfolio60.0%
E(Rp)7.20%
σp12.00%
PositionLending 40.0% at Rf
Show working

CAL slope = (10.00% − 3.00%) ÷ 20.00% = 0.350

E(Rp) = Rf + w × (E(R) − Rf) = 3.00% + 0.6 × (10.00% − 3.00%) = 7.20%

σp = w × σ = 0.6 × 20.00% = 12.00% (the risk-free asset adds no risk)

Weight from a target risk: w = σp ÷ σ. For σp 12% at this tangency: 12 ÷ 20.00 = 60.0% in the risky portfolio.

Calculator. TI BA II Plus: 0.1000 [−] 0.0300 [=] [×] 0.60 [+] 0.0300 [=] gives 0.0720. HP 12C: 0.1000 [ENTER] 0.0300 [−] 0.60 [×] 0.0300 [+] gives 0.0720.

Everyone holds the same risky portfolio; risk aversion only decides how much of it.

Start on the first tab and pivot the line until it touches the frontier: the tangency is the optimal risky portfolio. On the second tab, change A to see the investor’s point slide along the line. The default already shows an investor with A = 2.5 holding 70% in the risky portfolio.

The exam method is mechanical: compute U = E(r) − 0.5Aσ² for each point on the CAL and take the highest.

Go deeper The exact best weight

Maximizing U along the CAL gives a closed form for the weight in the risky portfolio. With these inputs, 0.07 ÷ (2.5 × 0.04) = 70% (so 30% is lent): E = 7.9%, σ = 14% and U = 0.079 − 1.25 × 0.0196 = 0.0545, a little above the 60% point’s 0.0540. An investor with A = 2 would hold 87.5% and one with A = 4 would hold 43.75%, so the more risk-averse investor lends more.

Optimal weight in the risky portfolio Know the idea
y∗=E(Ri)−RfA σi2y^{*} = \frac{E(R_i) - R_f}{A\,\sigma_i^{2}}
Best weight at A = 2.5
  1. 0.07÷(2.5×0.2x²)= 0.7

x² square

  1. 0.07ENTER2.5ENTER0.2ENTER××÷ 0.7

ENTER enter (on the HP, puts the number on the stack)

Rearrange itBest weight in the risky portfolio: solve for the weight or the risk aversion
The question asks for
The risk-free rate is 2.00%. A risky portfolio has an expected return of 8.00% and a standard deviation of 15.00%. An investor with a risk aversion coefficient of 4 maximizes U = E(r) − 0.5Aσ². The weight in the risky portfolio is closest to:

(0.08 − 0.02) ÷ (4 × 0.15²) = 0.6667, so 66.67% in the risky portfolio

Weight in the risky portfolio (decimal)0.6667

On your calculator
  1. 0.06÷(4×0.15x²)=a decimal, ×100 for percent

x² square

  1. 0.06ENTER4ENTER0.15ENTER××÷a decimal, ×100 for percent

ENTER enter (on the HP, puts the number on the stack)

Go deeper Borrowing at a higher rate, and the market portfolio

If investors must borrow at a rate above the lending rate, the CAL bends to a flatter slope beyond the risky portfolio, and not everyone shares one risky portfolio any more. When all investors share expectations and the optimal risky portfolio is the market portfolio, the CAL becomes the capital market line, the starting point for the next module.

Exam tip Two tangencies, two answers. The CAL touching the frontier gives the one risky portfolio everyone holds. An indifference curve touching the CAL gives how much of it you hold.

Memorize this

MemorizeTwo tangencies

NameWhereSame for everyone?
Optimal risky portfolioCAL touches the efficient frontierYes
Optimal investor portfolioindifference curve touches the CALNo: depends on A

Memory hook First tangency picks the risky portfolio, second picks how much of it. Everyone shares the first and only the second is personal.

Know it cold Same risky portfolio for all; risk aversion only sets the lending or borrowing.

MemorizeCAL formulas

Memory hook A straight line from Rf: intercept Rf, slope the Sharpe ratio, and σp is just the weight times the risky σ.

Know it cold E(Rp)=Rf+E(Ri)−Rfσi σpE(R_p) = R_f + \dfrac{E(R_i) - R_f}{\sigma_i}\,\sigma_p, with σp=w σi\sigma_p = w\,\sigma_i. Weight above 100% means borrowing at RfR_f.

MemorizeReading a point on the line

Weight in riskyPositionInvestor
0%risk-free asset, at Rflends everything
between 0% and 100%lending portfoliomore risk averse
100%the optimal risky portfolio
above 100%borrowing (leveraged) portfolioless risk averse

Memory hook Left of the risky portfolio you lend, right of it you borrow.

Two decisions behind every portfolio
Choosing a portfolio when a risk-free asset existstwo-fund separation: investment decision, then financing decision
  • 1. Investment decision Memorize pick the optimal risky portfolio: where the steepest CAL touches the efficient frontier
    • Same for every investor with the same expectations, whatever the risk aversion or wealth
  • 2. Financing decision Memorize pick the optimal investor portfolio: where the investor’s highest indifference curve touches the CAL
    • Lending below 100% in the risky portfolio; more risk averse
    • Borrowing above 100% in the risky portfolio, borrowed at Rf; less risk averse
Portfolios relative to the capital allocation line
Position against the CALthe line is the set of the best attainable portfolios
  • Above the line Use it desirable but not achievable with the available assets
  • On the line Memorize attainable; the optimal investor portfolio sits here
  • Below the line Use it attainable but dominated: more return is available at the same risk
Return and risk with a risk-free asset Memorize
E(Rp)=wfRf+(1−wf) E(Ri),σp=(1−wf) σiE(R_p) = w_f R_f + (1 - w_f)\,E(R_i), \qquad \sigma_p = (1 - w_f)\,\sigma_i
Quick example

30% in a bill yielding 1.5% and 70% in a risky portfolio expected to earn 7.5% with σ = 12%. E = 0.3 × 1.5 + 0.7 × 7.5 = 5.7%; σp = 0.7 × 12 = 8.4%. The bill adds no risk of its own.

On your calculator
  1. 0.3×1.5+(0.7×7.5)= 5.7
  2. 0.7×12= 8.4
  1. 0.3ENTER1.5×0.7ENTER7.5×+ 5.7
  2. 0.7ENTER12× 8.4

ENTER enter (on the HP, puts the number on the stack)

Capital allocation line Memorize
E(Rp)=Rf+E(Ri)−Rfσi σpE(R_p) = R_f + \frac{E(R_i) - R_f}{\sigma_i}\,\sigma_p
Quick example

Rf = 1.5%, risky portfolio E = 7.5%, σ = 12%. An investor who wants σp = 9% expects 1.5 + (6 ÷ 12) × 9 = 6.0%.

On your calculator
  1. 7.5−1.5=÷12=×9+1.5= 6
  1. 7.5ENTER1.5−12÷9×1.5+ 6

ENTER enter (on the HP, puts the number on the stack)

Slope of the CAL (market price of risk) Use it
Slope=E(Ri)−Rfσi\text{Slope} = \frac{E(R_i) - R_f}{\sigma_i}
Quick example

Rf = 1.5%, risky portfolio E = 7.5%, σ = 12%. (7.5 − 1.5) ÷ 12 = 0.50: 0.50 points of extra return for each point of risk.

On your calculator
  1. 7.5−1.5=÷12= 0.5
  1. 7.5ENTER1.5−12÷ 0.5

ENTER enter (on the HP, puts the number on the stack)

Optimal weight in the risky portfolio Know the idea
y∗=E(Ri)−RfA σi2y^{*} = \frac{E(R_i) - R_f}{A\,\sigma_i^{2}}
Quick example

Rf = 1.5%, risky portfolio E = 7.5%, σ = 12%, investor A = 5. y = 0.06 ÷ (5 × 0.0144) = 83.3% in the risky portfolio and 16.7% in the risk-free asset

On your calculator
  1. 0.06÷(5×0.12x²)= 0.8333

x² square

  1. 0.06ENTER5ENTER0.12ENTER××÷ 0.8333

ENTER enter (on the HP, puts the number on the stack)

How it is asked

  1. Expected return at a target risk

    Rf 2.5%, risky E 9.5%, σ 14%. Expected return at σp = 21%?

    Weight 21 ÷ 14 = 1.5, so E = 2.5 + 1.5 × 7 = 13.00%. Trap: 9.50%, which ignores leverage.

  2. Two-fund separation

    Identical expectations, different risk aversion. What do investors hold?

    The same optimal risky portfolio with different amounts of the risk-free asset.

  3. Which tangency?

    The optimal portfolio for a particular investor is the point where?

    The indifference curve touches the CAL. Trap: CAL touching the frontier is the optimal risky portfolio.

  4. Pick the best point on the CAL

    Table of CAL points and A = 2.5. Which is best?

    Compute U = E − ½Aσ² for each and take the highest. Trap: the highest return.

Exam traps

  • Thinking each investor has a different optimal risky portfolio. The risky portfolio is the same; the mix with the risk-free asset differs.
  • Computing σp as a weighted average that includes the risk-free asset. The risk-free asset has zero risk and zero correlation: σp = w × σi.
  • Mixing up the optimal risky portfolio (CAL and frontier tangency) with the optimal investor portfolio (indifference curve and CAL tangency).
  • Scaling the whole risky return by the leverage and forgetting the borrowing cost. The borrowed part earns the risky return and costs Rf.
  • Treating a point below the CAL as unattainable. It is attainable but dominated.

Checkpoint

4 exam-style questions. About 90 seconds each.

  1. 1The risk-free rate is 4%. A risky portfolio has an expected return of 12% and a standard deviation of 16%. An investor on the capital allocation line who wants a standard deviation of 20% will have an expected return closest to:

  2. 2According to the two-fund separation theorem, investors with identical expectations but different risk aversion will hold:

  3. 3The optimal portfolio for a particular investor is best described as the point where the:

  4. 4The risk-free rate is 2% and a risky portfolio has an expected return of 8% and a standard deviation of 15%. An investor with a risk aversion coefficient of 4 can hold 50%, 75% or 100% of wealth in the risky portfolio, with the rest in the risk-free asset. Using U = E(r) − 0.5Aσ², the investor most likely holds:

Key takeaways

  • CAL: E(Rp) = Rf + [(E(Ri) − Rf) ÷ σi] × σp; σp = weight in the risky portfolio × σi.
  • The optimal risky portfolio is where the steepest CAL touches the efficient frontier.
  • Two-fund separation: the same risky portfolio for everyone, different lending or borrowing.
  • Each investor’s optimal portfolio is where their indifference curve touches the CAL.
Return and risk with a risk-free asset Memorize
E(Rp)=wfRf+(1−wf) E(Ri),σp=(1−wf) σiE(R_p) = w_f R_f + (1 - w_f)\,E(R_i), \qquad \sigma_p = (1 - w_f)\,\sigma_i
Quick example

30% in a bill yielding 1.5% and 70% in a risky portfolio expected to earn 7.5% with σ = 12%. E = 0.3 × 1.5 + 0.7 × 7.5 = 5.7%; σp = 0.7 × 12 = 8.4%. The bill adds no risk of its own.

On your calculator
  1. 0.3×1.5+(0.7×7.5)= 5.7
  2. 0.7×12= 8.4
  1. 0.3ENTER1.5×0.7ENTER7.5×+ 5.7
  2. 0.7ENTER12× 8.4

ENTER enter (on the HP, puts the number on the stack)

Capital allocation line Memorize
E(Rp)=Rf+E(Ri)−Rfσi σpE(R_p) = R_f + \frac{E(R_i) - R_f}{\sigma_i}\,\sigma_p
Quick example

Rf = 1.5%, risky portfolio E = 7.5%, σ = 12%. An investor who wants σp = 9% expects 1.5 + (6 ÷ 12) × 9 = 6.0%.

On your calculator
  1. 7.5−1.5=÷12=×9+1.5= 6
  1. 7.5ENTER1.5−12÷9×1.5+ 6

ENTER enter (on the HP, puts the number on the stack)

Slope of the CAL (market price of risk) Use it
Slope=E(Ri)−Rfσi\text{Slope} = \frac{E(R_i) - R_f}{\sigma_i}
Quick example

Rf = 1.5%, risky portfolio E = 7.5%, σ = 12%. (7.5 − 1.5) ÷ 12 = 0.50: 0.50 points of extra return for each point of risk.

On your calculator
  1. 7.5−1.5=÷12= 0.5
  1. 7.5ENTER1.5−12÷ 0.5

ENTER enter (on the HP, puts the number on the stack)

Optimal weight in the risky portfolio Know the idea
y∗=E(Ri)−RfA σi2y^{*} = \frac{E(R_i) - R_f}{A\,\sigma_i^{2}}
Quick example

Rf = 1.5%, risky portfolio E = 7.5%, σ = 12%, investor A = 5. y = 0.06 ÷ (5 × 0.0144) = 83.3% in the risky portfolio and 16.7% in the risk-free asset

On your calculator
  1. 0.06÷(5×0.12x²)= 0.8333

x² square

  1. 0.06ENTER5ENTER0.12ENTER××÷ 0.8333

ENTER enter (on the HP, puts the number on the stack)

All Portfolio Construction formulas, every lesson

Practice exam-style questions on Portfolio Risk and Return: Part I

Questions about this lesson?

Where this comes back

Questions candidates ask

What is the capital allocation line?

It is the straight line of risk and return combinations from mixing a risk-free asset with a risky portfolio. It starts at the risk-free rate on the vertical axis, and its slope is the risky portfolio’s excess return per unit of risk, sometimes called the market price of risk. Points beyond the risky portfolio use borrowing.

What is the two-fund separation theorem?

It says every investor with the same expectations holds the same two funds: the risk-free asset and the optimal risky portfolio. The choice of risky portfolio (the investment decision) is separate from how much to lend or borrow (the financing decision), which depends on risk aversion.

What is the difference between the optimal risky portfolio and the optimal investor portfolio?

The optimal risky portfolio is where the capital allocation line touches the efficient frontier, and it is the same for everyone. The optimal investor portfolio is where one investor’s indifference curve touches that line, so it depends on their risk aversion.

Spotted an error? Tell us and we will fix it.

  1. How the major asset classes compare on return and risk
  2. Risk aversion, utility and indifference curves
  3. Portfolio variance, covariance and correlation
  4. The efficient frontier and the global minimum-variance portfolio
  5. The capital allocation line and the optimal portfolio

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