The following diagram depicts the Portfolio Frontier. What portion of this graph denoted as portion A, B and C, represents the Efficient Frontier?

Question

BlackTom AI · Accepted Answer

To evaluate which portion of the diagram corresponds to the Efficient Frontier, we need to recall what the Efficient Frontier represents in portfolio theory: it is the outer boundary of the feasible set of portfolios, consisting of those portfolios that offer the highest expected return for a given level of risk (or, equivalently, the lowest risk for a given return). In other words, any portfolio that lies inside the frontier is dominated by some portfolio on the frontier, and thus is not efficient.

Option by option analysis:

Option A: If A lies inside the feasible region (i.e., below or within the outer envelope), then for the same level of risk you could obtain a higher return by moving to a portfolio on the frontier, making A inefficient. If A were on the boundary but not on the upper envelope, it would not be efficient either. In any case, without being on the outermost boundary that constitutes the frontier, A does not meet the definition of efficient.

Option B: B is described as the portion that sits on the outer envelope of the feasible set—the highest return for each level of risk (or the lowest risk for each return). This is precisely the defining characteristic of the Efficient Frontier, so B represents the efficient portfolios.

Option C: Similar reasoning applies to C as for A. If C is not on the outer envelope of the feasible set (or if it lies below the frontier), it is dominated by a portfolio on the frontier and is therefore not efficient. The only way C could be considered efficient is if it were on the same outer boundary, but the prompt indicates B is the efficient portion.

Additionally:
- The option 'All answers listed are correct' would imply that A, B, and C all lie on the efficient frontier, which contradicts the notion of a single outer envelope as the efficient set in a standard diagram.
- If you consider A or C to be on the frontier, that would require them to be on the same outer boundary as B; however, the question’s provided correct answer is B, implying that B uniquely lies on the efficient envelope in this diagram.

In summary, the Efficient Frontier is the outer boundary of the feasible portfolios, and among the labeled portions, B is the one that lies on that boundary, representing the efficient set. A and C, being interior or not on the outer envelope, are not efficient portfolios.

The following diagram depicts the Portfolio Frontier. What portion of this graph denoted as portion A, B and C, represents the Efficient Frontier?

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