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

1) Efficient Frontier

The efficient frontier situation , it is based on the assumption that in a perfect market, there exists an optimal return for every level of risk assumed.

So in a graph , if we plot the optimal return for each level of risk assumed , we get a scatter diagram of risks vs return , independant of each other.

Once the plotting is completed, it is found that at times for the same level of risks, some stocks offer lesser returns. Once those levels are ignored, and a plot of the most efficient returns for a given level of risk is joined , we get a line known as the Efficient frontier.

Portfolios below that line, are suboptimal , and should be ignored.

2) Optimal Portfolio

When plotting Risk vs return line, it assumes that investors are so efficient that they try to optimally choose the best stocks for a given level of risk.

So the Line, lists the best return for a given level of risk.

The optimal portfolio balances the risk and return in the best possible way (since returns are not infinite, after a point , risk might keep increasing and returns start to flatten). Hence choosing the point at which the risk return slop yields the most optimal return for an acceptable risk, is the optimized portfolio.