Efficient Frontier
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. Portfolios that lie below
the efficient frontier are sub-optimal, because they do not provide enough return for the level of
risk. The Y axis of the efficient frontier shows the return on an investment and the X axis shows the
risk/volatility of the portfolio.
Questions - Use Your Note Taker To Jot Down Ideas / Calculations
1. Two assets are plotted vertically on the efficient frontier for investments graph. They are said to be:
a) efficient investments.
b) achieving different returns for the same level of risk.
c) achieving the same returns for differing levels of risk.
d) both low risk.
B)
Returns are shown on the Y axis of the efficient frontier graph and risk is shown along the X axis.
Therefore two securities with the same level of risk, as measured by standard deviation, will sit
vertically.
2. Jack and Jill, both rational investors, have portfolios that sit on the efficient frontier. Jack’s portfolio is situated to the left of Jill’s. This is most likely because:
a) Jack is more risk averse compared with Jill.
b) Jack needs to obtain higher potential rewards than Jill.
c) Jill is more risk averse compared with Jack.
d) Jack is a contrarian investor.
A)
The Y axis on the efficient frontier shows expected returns whereas the X axis shows risk as
measured by standard deviation. If a portfolio sits further less on the efficient frontier it is taking less
risk – so it can be said that as they both have efficient portfolios that Jack is more risk averse.
- Further Study Text: Pages 137-139