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Explain Efficient Frontier

The Efficient Frontier, introduced by Harry Markowitz, represents the set of optimal portfolios that maximize expected return for a given level of risk or minimize risk for a given expected return. It is visualized as the upper left boundary of a graph plotting risk against expected return, with portfolios on the frontier being the best trade-offs for investors. Portfolios below the frontier are suboptimal, while those above are unattainable, emphasizing the importance of diversification in achieving efficient portfolios.

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53 views2 pages

Explain Efficient Frontier

The Efficient Frontier, introduced by Harry Markowitz, represents the set of optimal portfolios that maximize expected return for a given level of risk or minimize risk for a given expected return. It is visualized as the upper left boundary of a graph plotting risk against expected return, with portfolios on the frontier being the best trade-offs for investors. Portfolios below the frontier are suboptimal, while those above are unattainable, emphasizing the importance of diversification in achieving efficient portfolios.

Uploaded by

Chandra Prakash 11 A 45
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

explain Efficient frontier

The Efficient Frontier is a foundational concept in modern portfolio theory, introduced by Harry
Markowitz in the 1950s. It refers to the set of optimal portfolios that offer the highest possible
expected return for a given level of risk or, alternatively, the lowest possible risk for a given
expected return.

Key Points about the Efficient Frontier


Portfolio Construction: When constructing a portfolio of assets (such as stocks), different
combinations will yield different expected returns and risk (standard deviation/volatility).
Optimal Portfolios: The efficient frontier is the collection of those portfolios that are not
dominated by any other—in other words, no other portfolio exists that offers higher return
for the same risk, or lower risk for the same return.
Visualization: If you plot risk on the x-axis and expected return on the y-axis for all possible
portfolios, the efficient frontier forms the upper left boundary of this cloud of points.
Investor Choice: Every rational investor would prefer a portfolio on the efficient frontier
because it represents the best possible trade-off between risk and return for their risk
appetite.
Diversification: Efficient portfolios are typically diversified, combining multiple assets in a
way that reduces risk through low or negative correlations among them.

Illustration
The curve starts from the minimum risk possible (minimum variance portfolio) and rises
upward to higher returns with increasing risk.
Portfolios below or to the right of the frontier are sub-optimal, as there are portfolios with
the same risk but higher expected return or the same return but lower risk.
Portfolios above the efficient frontier are impossible to achieve given current market
parameters.

Formula and Calculation


The precise shape and location of the efficient frontier depend on the expected return,
standard deviation, and covariance of asset returns.
The covariance matrix is essential: the less correlated the assets, the more you can reduce
overall portfolio risk by diversification.
Summary Table
Portfolio Location Description

On the Efficient Frontier Optimal risk/return mix for a given risk or return

Below/Right of Frontier Suboptimal (can improve return or reduce risk)

Above Frontier Not achievable

Practical Example
Suppose you have a choice of multiple assets:
If you invest all in a single risky stock, the risk is high.
By combining stocks (especially those not perfectly correlated), you can create a portfolio
whose risk is lower than the average of the component risks for a given return.
Thus, the efficient frontier is the “best” set of portfolios an investor can hold, forming the core
of rational investment strategies [1] [2] .

1. quant_finance.pptx
2. quantitative_finance.pptx

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