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Constructing efficient frontier and optimal portfolio

A. Construct a reasonable, but hypothetical, graph that shows risk, as measured by portfolio standard deviation, on the X axis and expected rate of return on the Y axis. Now add an illustrative feasible (or attainable) set of portfolios, and show what portion of the feasible set is efficient. What makes a particular portfolio efficient? Don't worry about specific values when constructing the graph-merely illustrate how things look with "reasonable" data.

b. Now add a set of indifference curves to the graph created for part b. What do these curves represent? What is the optimal portfolio for this investor? Finally, add a second set of indifference curves which leads to the selection of a different optimal portfolio. Why do the two investors choose different portfolios?

c. Now add the risk-free asset. What impact does this have on the efficient frontier?

Solution Summary

The solution contains two graphs completely marked with various components on the graph and illustrates the efficient frontier and optimal portfolio. It also explains in simple word the meaning of various items involved. By doing such problems the student will be able to strengthen the conceptual foundation.

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