Question

What is the difference between efficient frontier and capital allocation line? Please explain it from the perspective of their compositions? (4pts)

Answer 1

Efficient frontier defines as collection of portfolio that provides highest level of return at given level of risk. An efficient frontier is representing in term of area above which return is high but it is unachievable and below that area return is low at given level for risk so it is undesirable. So, all investor constructs their portfolio at efficient frontier line and earn maximum return at given level return. Components of efficient frontier are expected return and standard deviation of portfolio.

Capital allocation line is a graphical represent of risk of portfolio and above risk-free rate. capital allocation line represents return of portfolio at given level of risk. all investor cannot hold optimal portfolio and efficient frontier so construct portfolio of different assets with different weight of measure their risk at each level or risk above risk free rate. Components of capital allocation line is Risk free rate, expected return above risk free rate and standard deviation of portfolio. the slope of capital allocation line is called reward to volatility ratio.