Question

Can anyone help me to understand how to find out the optimal portfolio for

(i) 1 risky assets and a risk free assets

(2) 2 risky assets and a risk free assets

(3) 2 risky assets

With an example pls.

Answer 1

Fornfinding out an optimum portfolio, yoi have to firstly understand the concept of Efficient frontier line (EFL),and capital allocation line (CAL)

Efl is constructed by combining several combinations of assets with different characteristics say 1 asset is providing return of 10%, and having 5% standard deviation, similarly anpther asset is providing 12% return but SD here is 6%

Where standard deviation measures the riskiness of the asset.

By using all these combinations we construct a line known as Efl

A portfolio of risky assets and the risk free assets results in generatin of a line known as Capital allocation line.

Optimum portfolio refers to the line which is tangent to both the lines as shown in image

16.00% 14.00% Optimal Portfolio- 12.00% 10.00% Optimal CAL 8.00% 6.00% 4.00% 0.00% 5.00% 10.00% 20.00% 15.00% Portfolio standard deviation Portfolio expected return

Now in the given mentioned question % of the risky asset is not specified but to determine the optimum portfolio of suppose 1 risky asset which is less riskier, than we will have to move on capital asset line towards the y axis.

If suppose 2 risky assets, i.e. more risk than we will move towards x axis on capital asset line.

If just 2 risky asset and no risk free asset than standard deviation i.e. the risk will be quiet higher than both the 2 cases discussed earlier , so here we will have to move more towards right hand side on capital asset line.