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Explain the shape of the Markowitz (that is, mean-variance)

efficient frontier, specifically what causes it to be curved rather
than a straight line.

1 Answer

4 votes

Answer:

The Markowitz efficient frontier is a graphical representation of the set of optimal portfolios that provide the highest expected return for a given level of risk. The efficient frontier is derived from the mean-variance optimization model developed by Harry Markowitz in 1952.

The shape of the efficient frontier is curved rather than a straight line due to the non-linear relationship between expected returns and risk. In other words, the relationship between expected returns and risk is not proportional. As the level of risk increases, the expected return does not increase at the same rate. This is because the returns of different assets are not perfectly correlated, and diversification can reduce risk without sacrificing expected returns.

The curvature of the efficient frontier is also affected by the correlation between assets. When assets are perfectly positively correlated, the efficient frontier is a straight line. This is because the risk reduction benefits of diversification are not present when assets move in perfect lockstep. Conversely, when assets are perfectly negatively correlated, the efficient frontier is a curve that is concave to the origin. This is because the risk reduction benefits of diversification are maximized when assets move in opposite directions.

In summary, the Markowitz efficient frontier is curved rather than a straight line because of the non-linear relationship between expected returns and risk, as well as the impact of asset correlation on diversification benefits.

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