Explain the relationship between the possibility of lending and borrowing at a risk free rate and...

Explain the relationship between the possibility of lending and borrowing at a risk free rate and the Markowitz Efficient Frontier (MEF)

Expert Solution

The Markowitz efficient frontier consists of all the efficient portfolios which provide the maximum return for a given level of risk.

When the investors borrow at the risk free rate , all the portfolios created by borrowing at the risk free rate are risky portfolios of an aggressive investor and will lie right on the MEF . The right hand side of the efficient frontier will consists of securities which have the potential for high returns as they invest more than 100% of the investable funds in the risky portfolio by borrowing funds at the risk free rate and hence can earn higher potential returns. This strategy is only suitable for the high risk tolerant investor.

Conversely, securities that lie on the left end of the efficient frontier would be suitable for risk-averse investors. All the portfolios that are created by lending at the risk free rate and combining it with the market portfolio are conservative portfolios and will lie on the left of the MEH .

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