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EXAMPLE

To illustrate the concepts of dominance and efficient frontier, let us take a simple example with two assets X (expected return 10 per cent, standard deviation 15 per cent) and Y (expected return 20 per cent, standard deviation 26 per cent), low positive correlation between their returns permits diversification gains. A large number of portfolios can be formed by blending these assets in different proportions. Table 3.5 presents six such portfolios with their expected returns and risk. Shows a graph of these portfolios in risk-return space. Line segment AF depicts the minimum-variance portfolio opportunity set or the minimum-variance frontier of risky assets. Points A and F represent pure holdings (100 per cent) of assets X and Y respectively. There is an inflection at point C. This is the point to the extreme left on the minimum-variance frontier. Thus, it represents the global minimum valiance portfolio. Point F represents global maximum return portfolio. All portfolios along line segment CF are more efficient than portfolios along line segment AC. Thus. it is the efficient  frontier. Portfolios A and B are inefficient or dominated portfolios.

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