How do you graph an efficient frontier for a portfolio of risky assets?

Question

i have an excel macro that graphs the efficient frontier given the history of a stock, but i dont understand how the graph is made? can someone give me a thorough explaination of this stuff?

Answer 1

For a basic explanation of what is going on, see Brealey & Myers book FOUNDATIONS OF CORPORATE FINANCE. For a solid explanation, look at a PhD level finance book like Huang & Litzenberger.

The mathematics is not easy -- it involves optimization techniques.

The basic idea behind the efficient frontier is that you want to choose portfolios that have the highest possible expected return for a given level of risk (measured as volatility). You could start out by finding the portfolio of risky assets with the lowest volatility. That one is on the efficient frontier. Then you chould choose volatilities that are greater and for each one, find the portfolio with the maximum expected return. As you can imagine, this would take a lot of time.

Mathematically, there are some shortcuts -- but it isn't something that can be explained easily in this forum.

Answer 2

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