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Capital Market theory

Markowitz Model and Efficiency Frontier


Evolution of capital Asset Pricing Model
Dominant Portfolio
Separation Theorem
Capital Market Line
CAPM
Security Market Line
Application of CML and CAPM
Amit Singla

Markowitz Model and Efficiency


Frontier
Markowitz model of portfolio analysis
generates an efficient frontier, which is a
set of efficient portfolios.
A portfolio is said to be efficient if it offers
the maximum expected return for a given
level of risk of it offers the minimum risk
for a given level of expected return.
Efficient frontier is a set of efficient
portfolio.
Amit Singla

Evolution of capital Asset Pricing


Model
CAPM was developed in mid-1960 by William
Sharpe John Linter and Jan Mossin.
It explains the relationship that should exist
between the securities expected return and their
risk in terms of the means and standard deviation
about security returns.
CAPM is a direct extension of Markowitz model.

Amit Singla

Assumption of CAPM
All investors are considered to be efficient
investors who like to position themselves on the
efficient frontier.
Investors are free to borrow or lend any amount
of money at risk free rate of return.
All investors are expected to have homogeneous
expectations.
All investors have same investment time
horizons.
No transaction costs.
Inflation rate is fully anticipated.
All investments are correctly priced.
Amit Singla

Standard deviation Vs. Beta


Risk Free asset
Covariance of a risk-free asset with a risky asset
Combining a risk free asset with a risky portfolio
Risk return possibilities with leverage
Lending and borrowing at the riskless rate:
Combining any risky portfolio with a riskless asset produces a
linear relationship between their respective E(r), points
Combination of a risky portfolio with riskless asset are
generally reffered to as lending portfolios, since some of the
investment is invested or lent at the riskless rate.
When the percentage of portfolio invested in riskless security f
is negative, the resulting portfolio is reffered to as borrowing
portfolio.
As long as the E(rm)>rf investor could continue to borrow to
increase its expected return and risk and vice versa i.e.
lending.
Amit Singla

Dominant Portfolio
The portfolios on the line rfM always
dominate the portfolios on the efficient
frontier.
Because of this dominance, all investors
should choose efficient portfolio M.
M is the efficient portfolio that maximizes
the value of risk premium.
Amit Singla

Separation Theorem
The separation of investing (to lend) and
financing decisions (to borrow) is called
the separation theorem.

Amit Singla

Capital and security market line


The capital market line: A line used in the capital

asset pricing model to illustrate the rates of return for efficient


portfolios depending on the risk-free rate of return and the level of
risk (standard deviation) for a particular portfolio.

CAPM: A model that describes the relationship between risk


and expected return and that is used in the pricing of risky
securities.

Security market line: The line that graphs the

systematic or market risk versus return of the whole market at a


certain time and shows all risky marketable securities. (individual
Security)

Reconciling CML with SML


Amit Singla

Application of CML and CAPM


CML depicts the linear relationship between expected
return and total risk of all efficient portfolios; while SML
depicts the linear relationship between expected return
and systematic risk of all individual securities and all
portfolios.
Understanding of CAPM also covers the application of
the CML.
SML can be used for:
Evaluating the performance of portfolio
Test of asset pricing theories
Test of market efficiency
Identified mispriced securities
Amit Singla