Question

Given a simple world with two assets, a bond fund and a stock fund, clearly detail the steps involved in arriving at the 1) efficient frontier, and 2) market (optimal) portfolio.

Answer 1

SOLUTION:-

Fund A = Bond Fund

Fund B = Stock Fund

• Optimal Portfolio is basically a portfolio which maximize investor's need related to risk and return.
• It has highest risk and reward combination.
• So this portfolio will give highest return given a particular level of risk and lowest risk given a particular level of reward.

If We take all those optimal porfolios and graph them in risk and return profile, that will become the Efficient frontier

Steps:

1. Take the return and risk (standard deviation) value of fund A and B. Also find the correlation between A & B

2. Start with 0% in fund B and 100% in fund A

3. Find the portfolio return and risk.

4. Increase the % in A incrementally and find return and risk

5. Find the combination which will give you best return for a particulr level of risk and best return with lowest risk

For example: Lets assume at 10% standard deviation of your portfolio, your best return is 15%

15% Standard deviation of portfolio, return is 22% and so on

6. These will become your optimal portfolios

7. Plot those on a graph with standard deviation on x axis and return on y axis

8. This will give you your efficient frontier

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