Imagine there are only two efficient portfolios of risky assets, EP1 and EP2. EP1 offers 10% return and 4% risk. EP2 offers 16% return and 20% risk. An investor has $100 to invest and may borrow or lend at the same risk free rate of 4%. Explain which efficient portfolio of risk assets is preffered by the investor ?
To evaluate the efficient portfolio we will have to look at the Sharpe ratio to analyse how good is portfolio in terms of risk-reward
Sharpe Ratio = (Rp-Rf)/(Standard Deviation)
Sharpe ratio : Portfolio A (Za)= (.10-.04)/.04= 1.5
Sharpe ration: Portfolio B (Zb)= (.16-.04)/.20=0.6
Shape ration of portfolio A is lesser than Porfolio of B.
Therefore Portfolio A is better for investment.