EFFICIENT FRONTIER

The efficient frontier is a group of optimal portfolios that offers the highest expected
return for a given level of risk or the lowest risk for a defined level of expected return.
Portfolios that lie under the efficient frontier are sub-optimal because they do not give
enough return for the level of risk. We set four returns between 0.80% and 2.8% and
calculated their minimum variance and weights such that their sum is equal to one.

We don’t have any negative weights so there is no need to repeat the work if short
selling is not allowed.

SHARPE RATIO

The Sharpe ratio is used to help investors understand the return of an investment
compared to its risk, it is equal to the average return earned in excess of the risk free
rate per total risk. It is the slope of the capital allocation line which is equal to the
incremental return of the portfolio to the incremental increase in risk. First we get the
monthly risk free rate from Thomson Reuters by finding the average between the bid
yield and ask yield then we divide it by 12 because we want to it for each month. We
find the Sharpe ratio equal to 0.4059 but we need to maximize it in order to find the
optimal portfolio which is the tangency point between risk free asset and efficient
frontier 2.66% return and 0.046 level of risk.

Return Risk
Max. Sharpe Ratio 0.64864539
2.66% 0.0460616

ALLOCATION BETWEEN F AND O

Since all investors choose the same optimal portfolio, they differ in the allocation
because it depends on their level of risk aversion so investors should determine how
much risk they are willing to take on in order to allocate their portfolios based on their
decision so it’s a separation theorem. My target return is 2% so after calculations I
found that 74% of my investment is in the risky assets and 26% in risk free portfolio,
the risky portfolio is made of three securities and each one has a specific percentage
depending on its return so we can calculate them and find the allocation in each
company.

MNST 10.36%
MCO 63.64%
MOS 0%
Risk free asset 26%
 Total 100%

CONCLUSION

We can deduce that the optimal portfolio doesn’t include securities with the highest
potential return or low-risk securities, it aims to balance securities with the greatest expected
returns with an acceptable degree of risk and where those portfolios lie are known as the
efficient frontier. As we have seen in order to get our target return we should invest in both
the risky securities and the riskless asset and allocate them based on the percentage that we
got. Also we concluded that portfolio risk can be reduced by diversification because different
assets respond differently to the economic conditions which lead investors to move from one
class to another to profit from the changing conditions and to reduce risk. Finally, we can see
that most of the money is allocated in Moody’s Corporation based on its high return with its
low level of risk and nothing in the Mosaic Company.