Efficient Frontier and Indifference Curves: CFA® Level 1 Exam Answer

CFA® Level 1 Exam Answer

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Question

The graph below combines the efficient frontier with the indifference curves for two different investors, X and Y (represented by U(X) and U(Y)). The letters A, B,

C, and D represent four distinct portfolios.

Which of the following statements about the above graph is CORRECT?

Answers

A. The backward bend in the efficient frontier is due to less than perfect correlation between portfolio assets.

B. Investor X would be better off moving to indifference curve U(X)1 and Portfolio C because of the higher return on that portfolio.

C. Investor X is less risk-averse than Investor Y.

D. Portfolio B is an optimal portfolio, Portfolio A is suboptimal. A

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Explanations

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A. B. C. D.

Explanation

This statement is true. Markowitz was the first person to recognize that there are no perfectly positively correlated assets or perfectly negatively correlated assets.

Thus, the efficient frontier has the shape noted above.

The other choices are incorrect. The optimal portfolio for each investor is on the highest indifference curve that is tangent to the efficient frontier. Thus, portfolios A and B are both optimal portfolios, but for different investors. In addition, any portfolio on the efficient frontier is superior to one that is not. Thus, Investor X would not be better off with Portfolio C (this portfolio is on a lower indifference curve and has more risk.) Investor X has a steep indifference curve, indicating that he is risk-averse. Flatter curves, such as those for investor Y, indicate a less risk-averse investor.

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