Question

Suppose that there are two risky assets to invest in. One offers a higher return than the other, but it also has a higher standard deviation. Will one of these assets always lie on the efficient frontier? explain in 800 to 1000 words.

Answer 1

The efficient frontier is the set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.

Optimal portfolios that comprise the efficient frontier tend to have a higher degree of diversification than the sub-optimal ones, which are typically less diversified.

The investor would select securities that lie on the right end of the efficient frontier. The right end of the efficient frontier includes securities that are expected to have a high degree of risk coupled with high potential returns, which is suitable for highly risk-tolerant investors. Conversely, securities that lie on the left end of the efficient frontier would be suitable for risk-averse investors.

Efficient Portfolios: That is when investors seek to maximize the expected return from their investment given some level of risk they are willing to accept. Risk Aversion: Individuals according to those theories are assumed to be risk averse: is one who, when faced with two investments with the same expected return but two di¤erent risks, will prefer the one with the lower risk. Risky assets: Those are the ones which the return that will be realized in the future is uncertain. Corporate bonds are riskier than public bonds, because of the possibility of default, in‡ation and so on. Assets in which the return that will be realized in the future is known with certainty today are referred to as risk-free assets or riskless assets.

Since riskiness a¤ects return, we must be able to measure the degree of risk associated with an investment in order to understand the relationship between risk and return. The most common measures are the Variance and the Standard Deviation. In …nancial context, we use the variance to measure the variability of returns from the average return; the greater the deviation from the average, the more variable the rate of return and the higher the level of risk.