Question

(a)

Based on the return and risk profile of the four portfolios below, discuss which portfolio cannot lie on the efficient frontier as described by Markowitz?

Portfolio         Expected Return      Standard Deviation

U                                 9%                              21%

V                                 5%                              7%

W                                15%                            36%

X                                 12%                            15%

(b)

Draw a kinked capital allocation (CAL) line first. And then discuss what causes the line to be kinked.

Answer 1

Answers-

Q a)

The correct option is Portfolio U. It cannot lie on the efficient frontier as described by Markowitz.

As expected return of portfolio U is 9 % but it has higher standard deviation of 21 % compared to Portfolio X which has an expected return of 12 % with standard deviation of 15 %. therefore Portfoilio X is giving higher returns at lower standard deviation compared to portfolio U.

Q b)

Here in the above figure we can see that at point X the Capital Allocation Line (CAL) is kinked.

CAL is kinked when investment in a complete portfolio is leverage and when the borrowing rate is greater than risk free rate.The reward-to-volatility ratio or the slope of CAL gets reduced and therefore CAL is slightly flattened or kinked.