Question

Explain the sense in which your frontiers can be described as ‘efficient’, and the difference (if any) between your restricted and unrestricted efficient frontiers. Which is the more efficient?           

Answer 1

A frontier is called as efficient when it contains a set of ideal or optimal portfolios expected to give the highest return at a minimum level of return. This is basically formed by plotting expected return on y-axis & standard measure as a measure of risk on the x-axis. It showcases the risk-return trade off. Portfolios lying below the Efficient Frontier are sub-optimal as they dont provide adequate return for that level of risk. A risk-seeking investor would go for securities towards right end of efficient frontier giving high return at higher risks, where as a risk-averse would look for left hand secuirities.

We need three measures to build a Frontier:

1. Expected Return

2. Variance/Standard Deviation

3. Covariance of one asset's return to the other

In some instances, the efficient frontier can be extended beyond the maximum return portfolio if an investor sells short. These short sales increase returns infinitely with greater risks. The aapproval of short sales extends the efficient frontier causing an infinite upper bound. This leads to an Unrestricted Efficient Frontier.

The Efficient Frontier with no short sales allowed inolves an investor holding a Restricted Efficient Frontier.

Restricted Efficient Frontier is more efficient as it cannot include any interior protfolios, that is, more risk for same return or less return for same risk.

Hope this answers your question.

Feel free to ask any further questions.