What is the concept of an efficient frontier in portfolio theory?

• A. The set of optimal portfolios that offer the highest expected return for a given level of risk.
• B. The single risk-free portfolio.
• C. The portfolio with the lowest return.
• D. A random collection of portfolios.

Answer: (B)

The efficient frontier represents the best possible trade-offs between risk and expected return for a given set of assets. It’s the upper boundary of all feasible portfolios when you plot expected return against risk (standard deviation). On the frontier, for any level of risk, you cannot find a portfolio with a higher expected return; and for any level of return, you can’t find a portfolio with lower risk along that boundary.

A single risk-free portfolio is just one point with zero risk, not the entire frontier. The frontier consists of many portfolios with varying levels of risk and return. When a risk-free asset is involved, you can form combinations that lie on the Capital Market Line, which is tangent to the frontier and shows the best risk–return trade-offs combining the risk-free asset with risky portfolios.