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▪ Capital market theory extends portfolio theory
and develops a model for pricing all risky assets,
while capital asset pricing model (CAPM) will
allow you to determine the required rate of return
for any risky asset.
▪ Applying the CML using this relevant risk measure
E(R M ) − RFR
E(R i ) = RFR + i riM [ ]
M
▪ Let βi=(σi riM) / σM be the asset beta measuring the relative risk with the
market, the systematic risk
▪ The CAPM indicates what should be the expected or required rates of
return on risky assets
E(R i ) = RFR + i [E(R M ) − RFR ]
▪ This helps to value an asset by providing an appropriate discount rate to
use in dividend valuation models
▪ Rm is market return ( expected return of the market)
The Security Market Line (SML)
▪ The SML is a graphical form of the CAPM
▪ The expected rate of return of a risk asset is determined by the
RFR plus a risk premium for the individual asset
▪ The risk premium is determined by the systematic risk of the asset
(beta) and the prevailing market risk premium (RM-RFR)
▪ Assumptions of Capital Market Theory
▪ All investors are efficient investors who want to target
points on the efficient frontier
▪ Investors can borrow or lend any amount of money at
the risk-free rate of return (RFR)
▪ All investors have homogeneous expectations; that is,
they estimate identical probability distributions for
future rates of return
▪ All investors have the same one-period time horizon
such as one-month, six months, or one year
Assumptions (Continued)
▪ All investments are infinitely divisible, which means
that it is possible to buy or sell fractional shares of
any asset or portfolio
▪ There are no taxes or transaction costs involved in
buying or selling assets
▪ There is no inflation or any change in interest rates,
or inflation is fully anticipated
▪ Capital markets are in equilibrium, implying that all
investments are properly priced in line with their risk
levels
Development of Capital Market Theory
▪ The major factor that allowed portfolio theory to
develop into capital market theory is the concept of
a risk-free asset
▪ An asset with zero standard deviation
▪ Zero correlation with all other risky assets
▪ Provides the risk-free rate of return (RFR)
▪ Will lie on the vertical axis of a portfolio graph
▪ Covariance with a Risk-Free Asset
▪ Covariance between two sets of returns is
n
Covij = [R i −E(R i )][R j −E(R j )]/n − 1
i=1
▪ Because the returns for the risk free asset are certain,
thus Ri = E(Ri), and Ri - E(Ri) = 0, which means that the
covariance between the risk-free asset and any risky
asset or portfolio will always be zero
▪ Similarly, the correlation between any risky asset and
the risk-free asset would be zero too since rRF,i= CovRF, I
/ σRF σi
▪ Combining a Risk-Free Asset with a Risky Portfolio, M
▪ Expected return: It is the weighted average of the two returns
E(R port ) = WRF (RFR) + (1 - WRF )E(R M )
▪ Standard deviation: Applying the two-asset standard deviation formula,
we will have Weight of risky
Weight of risk assets
free rate asset
σRF =0
Since σRF =0, σport =(1-WRF)σM
port = w 2RF RF
2
+ (1 − w RF ) 2 M2 + 2 w RF (1 - w RF )rRF, M RF M
▪ Estimate return = long-term returns a stock is likely to generate if purchased at its
current stock price.
ER = (Expect Price – Current Price + Expected Dividend) / Current Price
▪ Estimate return = long-term returns a stock is likely to
generate if purchased at its current stock price.
▪ ER = (Expect Price – Current Price + Expected Dividend) /
Current Price
▪ Required rate = the minimum rate investor will accept
Rules:
▪ If Req. < Est. = Undervalued
▪ If Req. > Est. = Overvalued
▪ A market portfolio is a theoretical bundle of investments that
includes every type of asset available in the investment universe.
Thus, it carries highest level of risk premium per unit
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or
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duplicated, or posted to a publicly accessible website, in whole or in part.
▪ The Capital Market Line
▪ With these results, we can develop the risk–return relationship
between E(Rport) and σport
E(R M ) − RFR
E(R port ) = RFR + port [ ]
M
▪ This relationship holds for every combination of the risk-free asset
with any collection of risky assets
▪ However, when the risky portfolio, M, is the market portfolio
containing all risky assets held anywhere in the marketplace, this
linear relationship is called the Capital Market Line (Exhibit 8.1)
Developing the Capital Market
Line
Risk-Return Possibilities with Leverage
▪ One can attain a higher expected return than is available
at point M
▪ One can invest along the efficient frontier beyond point
M, such as point D
▪ With the risk-free asset, one can add leverage to the
portfolio by borrowing money at the risk-free rate and
investing in the risky portfolio at point M to achieve a
point like E
▪ Clearly, point E dominates point D
▪ Similarly, one can reduce the investment risk by lending
money at the risk-free asset to reach points like C (see
Exhibit 8.2)
Suppose you have a riskless security at 4% and a market
portfolio with a return of 9% and a standard deviation of
10%. How should you go about investing your money so
that your investment will have a risk level of 15%?
• Portfolio Return
E(Rport)=RFR+σport[(E(RM)-RFR)/σM)
=4%+15%[(9%-4%)/10%]=11.5%
1-(-0.5)
• Money invested in riskless security, wRF
11.5%= wRF (4%) + (1-wRF )(9%) ----> wRF= -0.5
• The strategy is to borrow 50% in riskless asset and
150% in market portfolio. (risk takers)
E(Rrfr) E(Rm)
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