CHAPTER 8

CAPITAL
MARKET THEORY
 LEARNING OBJECTIVES:
☺Explain the Markowitz portfolio theory.
☺Discuss the capital market theory
assumptions.
☺Discuss the concept of capital asset pricing
model (CAPM);
☺Elaborate on the expected return to a
portfolio composed of two assets.
 Markowitz
Portfolio Theory
Capital Market Theory
Capital market theory extends portfolio
theory and develops a model for pricing
all risky assets. It is a model that seeks
to price risky assets, most commonly
shares in terms of trade-off between
the returns sought by investors and the
inherent risks involved.
MARKOWITZ POTFOLIO THEORY
 Capital market theory is built upon the
Markowitz portfolio theory. Markowitz
portfolio theory identifies an efficient
frontier, which is a set of efficient
portfolios.
Efficient portfolio represents the set of
portfolios with the maximum rate of return
for every given level or risk, or the
minimum risk for every level of return.
 A “portfolio” is a collection of
investments real and financial.
Market Portfolio is a portfolio
consisting of all securities where the
proportion invested in each security
corresponds to its relative market
value.
The capital market line(CML)
 
The linear efficient set of CAPM is known as the capital
market line, which has the following equation:

Where:
= Expected return of an efficient portfolio
= Risk-free rate of return
= Expected return of the market portfolio
= Standard deviation of the market portfolio
= Standard deviation of an efficient portfolio
Capital market
theory
assumptions
The main assumptions of the capital
market theory according to Reilly and
Brown (2009) are:
1. All investors are rational and evaluate
investments in terms of expected return and
variance (or standard deviation)
2. Investors can borrow or lend unlimited amounts at
the risk free rate,
3. All investors have homogenous expectations , that
is they estimate identical expected returns,
variances and covariance's
4. All investors have the same one period
investment horizon
5. All investments are infinitely
divisible.
6. There are no taxes or
transaction costs.
7. Inflation is fully anticipated and
interest rates are constant.
8. Capital markets are in
Capital asset
pricing model
(CAPM)
Capital Asset Pricing Model
(CAPM)
CAPM is developed when William F. Sharpe, a 26-
year-old researcher at the RAND Corporation, a think
tank in Los Angeles, introduced himself to a fellow
economist named Harry Markowitz.
CAPM explains that every investments carries two
distinct risks:
1. Systematic risk- the risk of being in the market
2. Unsystematic risk- the risk specific to a company’s
fortunes.
CAPM helps measure portfolio risk and the return an
investor can expect for taking the risk. It explains
the relationships that should exist between the
securities expected returns and their risks in terms
of the means and standard deviation.
The following equation describes the expected
returns on all assets and portfolios, whether
efficient or not .
E(RI) = RF + βI [E(RM) – RF]
Where E(RI) = expected return on asset i
RF = risk-free rate of return
βI = Cov (RIRM)/Var(RM)
E(RM) = expected return on the market portfolio
The graph for this equation is called the security market
line(SML). Security market line(SML) is a graphical
representation of CAPM, a basic estimate of the
relationship between risk and return in a stock price.
Security Market Line
CAPM is an equation
E (R)
describing the expected
return on any asset (or
portfolio) as a linear function
of its beta, β, which is
E(RM)
measure of the asset’s
sensitivity to movements in
RF
the market. CAPM states
that expected return has two
Beta
components: first the risk
1 free rate, RF, and second an
extra equal to βI [E(RM) – RF]
The market risk premium([E(RM) – RF ])is multiplied by
the asset’s beta β, a beta of 1 represents average
market sensitivity, and we expect an asset with that
beta to earn the market risk premium exactly.
A beta greater than 1 indicates greater than average
risk, and according to CAPM earns a higher expected
excess return.
A beta less than 1 indicates less than average
market risk and according to CAPM earns a smaller
expected excess return
 Expected excess returns are related only to market
risk, represented by beta. Sensitivity to the market
return is the only source of difference in expected excess
returns across assets. The market portfolio itself has a
beta of 1, as ΒM = Cov (RIRM)/Var(RM) = Var(RM) / Var(RM)
=1.
CAPM describes a financial market equilibrium in the
sense that if the model is correct and any asset’s
expected return differs from its expected return as given
by CAPM, market forces will come into play to restore
the relationships specified by the model.
Expected return to
a portfolio
composed of two
assets.
Mean-Variance Analysis
Mean-variance analysis is part of modern portfolio theory
that deals with the trade-offs between risk, as represented
by variance or standard deviation of return and expected
return. Mean-variance analysis assumes the following:
1. Investors are risk-averse
2. Assets’ expected returns, variance of return, and
covariance of return are known.
3. Investors need to know only the expected returns, the
variance of returns, and covariance's between returns in
order to determine which portfolios are optional.
4. There are no transaction costs or taxes.
For any portfolio composed of two assets the expected
return to the portfolio is the expected return to asset 1 plus
the expected return to asset 2.
E(RP) = w1E(R1) + w2E(R2)
where E(RP) = expected return of the portfolio
w1 = weight of asset 1
E(R1) = expected return on asset 1
w2 = weight of asset 2
E(R2) = expected return on asset 2
 In general, the expected return on a portfolio is the
weighted average of the expected returns on the individual
assets, where the weight applied to each asset’s returns is
the fraction of the portfolio invested in that asset. The
global minimum-variance portfolio is the portfolio of risky
assets having the minimum variance.
The introduction of a risk-free asset into the portfolio
selection problem results in the efficient frontier having a
linear portion that is tangent to the efficient frontier
defined using only risky assets. This line is called the
Capital Allocation Line(CAL).
The tangency portfolio is the market portfolio of risky
assets held in market value weights.
☺THANK YOU FOR LISTENING!!
Group 8
Bundalian, Precious Ann Q.
Manahan, Maria Cristina G.
Pamajilan, Carla Sabrina V.
Ronquillo, Emijiano M.
Umali, Trisha Mae