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Building the Perfect Generation Portfolio

Finding and applying the efficient frontier.

Fortnightly Magazine - September 2005

curve invokes even higher risk and return. In Figure 6, this "portfolio" is completely undiversified, lending itself to extremely high volatility and reward.

This portfolio consists of just one asset class—and this is to be expected since the highest risk-reward portfolio should in fact be undiversified and would consist of the highest risk-reward asset as defined earlier in Table 1. This proves to be the case since the “CC Gas West” power plant option is characterized by the highest expected value of return (m) and highest volatility of return (s).

While the efficient frontier curve shows the range of expected returns—and associated risk—for the entire spectrum of possible efficient portfolios, each point on the line can be viewed in greater detail. By plotting the probability distribution of returns from our low, medium and high risk-reward portfolios, we can compare them as in Figure 5.

Figure 5 clearly shows the behavior of three wholly different portfolio approaches—again, all of which are efficient:

  • The low risk-return portfolio has a very narrow bandwidth of return—an expected value of $107 million with a ±2d range of $77 million to $137 million.
  • The medium risk-return portfolio has a broader bandwidth of return—an expected value of $160 million with a ±2d range of $32 million to $288 million.
  • The high risk-return portfolio has an extremely broad bandwidth of return—an expected value of $174 million with a ±2d range of between -$82 million and $430 million.

Selection of one of these portfolios or of any portfolio point on the efficient frontier curve is a function of a firm's comfort level with risk.

The efficient frontier is a powerful and insightful approach to portfolio assessment. In our power-plant portfolio case study, Crystall Ball's OptQuest efficient frontier module does in fact converge on the efficient frontier—where the portfolios represent the highest expected return for any given level of risk. The asset allocations adequately reflect the shifting of asset risk intensity according to the efficient frontier's requirements-higher risk-return portfolios contain fewer higher-risk/higher-return assets.

No particular asset allocation is best—allocations need to be based on an organization's risk profile. The efficient frontier then enables appropriate allocation. A detailed study of efficient frontier can provide key business information for succeeding in the power industry—information that few organizations in the industry possess. The results are well suited for general risk analysis and risk management, portfolio planning and restructuring, power plant acquisition, development, and divestiture.

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