Efficient Frontier and Bond Maturity - Assignment Example

Efficient Frontier and Bond Maturity

Efficient frontier refers to a collection or set of optimal portfolios or assets that will yield the greatest expected return to a defined level of risk or the lowest risk for a given level of expected return hence the term efficient. This idea was developed by Henry Markowitz and Bill Sharpe normally people want to get a higher return but the higher the return the higher the risk. It is not advisable to have a low-risk security e.g. stocks since the return will also be below, however, it will depend on how the securities which are risky are combined in the portfolio. This will help out during fluctuation in the price of the securities in the portfolio. If data from the set of securities are gathered and plotted on a graph with an annual rate of return on the y-axis while the standard deviation of the cost of the security on the x-axis, there will be a region bounded by a curve sloping up. This curve is referred to the as efficient frontier.

Characteristics of the efficient frontier

 The first characteristics are that the portfolios that give the highest return are the ones selected, this portfolio is the one that lies above the curve referred to the as efficient frontier. Those points found above the efficient frontier give the best return for the portfolio as opposed to those that are below sometimes referred to as submerged points.

The second characteristic of an efficient frontier is that it is a curve not s straight line. This is because the return securities in the portfolio are not the same each security has its own level of return and risk associated with it (Hirt & Block, 1990). So any point found on this curve is the best alternative or asset to be included in the portfolio.

Yes they do.  First, because the points in the frontier keep on moving as time progresses the risk level and expected return change. This will result in the point associated with that security moving upwards if the changes were favorable. Secondly efficient frontier depends on the number of securities in the portfolio, so if securities in a given portfolio are of good number there is a high chance of some points being on top of the efficient frontier.

Yes, it is possible if the bond has a lower coupon rate hence the longer period of payment. Bond duration refers to the weighted average period of time required before the actual cash flows start to be received. The weighted average is not the nominal value of the cash flow but rather the present value. According to (Fabozzi, 2002) investors really need to know the duration for them to know or predict how the market price of a bond will be affected by due to changes in interest rates. If the interest rate increases this will reduce the duration required for a bond to mature.

If a bond has a short maturity and as expected its duration also needs to be short, but sometimes this is not the case. The duration period becomes longer than those of long-maturity bonds this can be attributed to changes in interest rate.