Question

1. Under MPT (Modern Portfolio Theory), what do the risk-free rate and the optimal risky portfolio create and why is it important relative to all other possible portfolios (with the exception of the optimal risky portfolio)?

Answer 1

what do the risk-free rate and the optimal risky portfolio create?

They create a portfolio with the maximum utility that lies on the efficient Frontier.

1. Modern portfolio theory assumes that investors are rational.
2. They want to maximize the utility of their portfolio.
3. According to modern portfolio theory utility is a positive function of return and negative function of risk.
4. To calculate portfolio with maximum utility, we calculate the coefficient of variation.
5. Coefficient of variation is standard deviation divided by the return of the portfolio.
6. Lower the coefficient of variation, the better, the lower the unit of risk per unit of return.
7. The portfolio with a lower coefficient of variation in the pool of portfolio- lies on efficient Frontier.
8. So a portfolio on efficient Frontier gives the lowest amount of risk per unit of return.
9. That's why we invest in the portfolio on efficient Frontier rather than portfolio below the Efficient Frontier (inefficient portfolio/all other possible portfolios).

We want to invest in such a way due to utility maximization approach.