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Capital Market Theory

Capital Market Theory. Outline. Overview of Capital Market Theory Assumptions of Capital Market Theory Development of Capital Market Theory Risk-Return Combination Risk-Return Possibilities with Leverage. From Portfolio Theory to Capital Market Theory.

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Capital Market Theory

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  1. Capital Market Theory

  2. Outline • Overview of Capital Market Theory • Assumptions of Capital Market Theory • Development of Capital Market Theory • Risk-Return Combination • Risk-Return Possibilities with Leverage

  3. From Portfolio Theory to Capital Market Theory • Capital market theory builds on portfolio theory and develops a model for pricing all risky assets • The concept of a risk-free asset is critical to the development of capital market theory • The expected return on a risk-free asset is entirely certain and the standard deviation is zero • Covariance of a risk-free asset with a risky asset is zero

  4. Expected Return of a Portfolio that contains a risk-free asset and a risky asset E(Rp) = w x E(rA) + (1-w) x rf • Standard Deviation of two asset portfolio • Expected return and the standard deviation of expected return for such a portfolio are linear combinations • A graph of possible portfolio returns and risks will be a straight line between the two assets

  5. Risk-return possibilities with Leverage • How can an investor attain a higher expected return than is available at point M in the graph? • Borrowing and lending possibilities and capital market line • Risk-less asset created lending and borrowing possibilities and a set of expected return and risk that did not exist before

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