CAPITAL MARKET THEORY

# CAPITAL MARKET THEORY - CAPITAL MARKET THEORY Objectives...

This preview shows pages 1–5. Sign up to view the full content.

CAPITAL MARKET THEORY Objectives Under capital market theory we examine three asset pricing models models that specify the behaviour of asset returns and the relation between the assets' risks and returns. These are: 1. The Capital Market Line (CML) 2. The Capital Asset Pricing Model (CAPM) 3. The Single Index Model (The Market Model or the ‘Security Characteristic Line’) At the end of this module, students should be able to clearly interpret each model, specifying the assumptions underlying each model, what each model represents about the behaviour of asset returns and in what circumstances each model is applicable. Students should also be aware of the uses to which each model can be applied and the strengths and weaknesses of each model . Relevant reading: BKM - Chapters  8, 9 Readings from the Articles Folder in Blackboard: 1. Regression Analysis.doc 2.  How to do regression analysis using EXCEL.pdf

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
The sequence of topics discussed 1. The Capital Market Line 1. Portfolio diversification and the concept of beta risk 1. The Capital Asset Pricing Model  1. Index Models and the calculation of ex-post betas 1. The estimation of ex-ante betas
The Capital Market Line (CML) The CML is derived from Markowitz Portfolio Theory. The CML gives the relation between the returns and risks of efficient portfolios and is a model that can be used to price efficient portfolios. Derivation of the CML Recall our framework for optimal portfolio selection in a universe of risky assets and the risk free asset, R f . The investor will prefer portfolios with higher utility than Q (such as S) by selecting a portfolio on the line R f Z. Portfolios on R f Z can be achieved by forming a linear combination between R f and the (risky) tangent portfolio T. Linear combinations result because R f is a risk free asset. The portfolio of risky assets our investor will now wish to hold is T rather than portfolio Q. Portfolios between the points R f and T represent positive weights invested in the risk free asset (lending) and in T while points from T to S represent negative weights on the risk free asset (borrowing) and over 100% weight on the tangent portfolio. E(r) std.deviation . . . . . . . . . . . X Y Q Rf S T Z

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
2. Assume that all investors have homogeneous expectations Every investor sees the same efficient frontier and so, every investor will invest in T. Then T becomes M, the portfolio of all risky assets. This is called the market portfolio . We now have the result that every investor will invest part of their wealth in the market portfolio and the balance in R f in order to reach their optimal portfolio on the R f T line. Since every investor holds a portfolio on the line R f T the equation of this line will specify the relation between returns and risks of efficient portfolios.
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

### What students are saying

• As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

Kiran Temple University Fox School of Business ‘17, Course Hero Intern

• I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

Dana University of Pennsylvania ‘17, Course Hero Intern

• The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

Jill Tulane University ‘16, Course Hero Intern