Capital Market Theory talks about pricing of risky assets in Capital Markets and is based on Markowitz Portfolio Management Theory.
Assumptions of Capital Market Theory:
- All investors are efficient investors which follow Markowitz concept of efficient frontier and invest in securities along the efficient frontier line looking at the expected return and variance.
- All investors can borrow or lend unlimited amount of money at a risk-free rate of return.
- All investors have same probability of outcome for expected rates of return, variance of return and correlation matrix.
- All investors have same time horizon for investment like one month, six months, 12 months.
- There are no transaction cost or taxes involved in buying or selling of assets.
- There is no inflation or change in interest rates.
- All assets are infinitely divisible and buying or selling of fractional shares of any asset or portfolio is allowed.
- Capital markets are in equilibrium and they are efficient such that asset prices properly reflect market condition.
Although some of these assumptions of this theory are unrealistic in nature, but this theory explains quite well the rate of returns on risky assets, so this theory is very useful.
Capital Market Line (CML):
Capital Market Line is a line in a graph of expected return taken on Y- axis versus Portfolio Sigma (risk – standard deviation) taken on X – axis and originating from the point of risk free rate of return in Y-axis and it is tangent to the Efficient Frontier. Here the portfolio is diversified having only systematic risk beta and expected return is equal to the expected market return. The point of tangency is called Market Portfolio and it consists entirely of risky assets. Portfolio on CML will have same Sharpe Ratio as that of Market Portfolio. Sharpe Ratio is named after William F. Sharpe and is the excess return per unit deviation of investment in an asset.
The CML equation is given as:
Where Rp = Return on Portfolio
Rf = Risk free rate of return
∑p = Portfolio Risk
Rm = Market Return
∑m = Market Portfolio Risk
Investor can go for lending from the risk-free rate of return point on Y-axis till the point of tangency which is the market return point. Beyond that he can go for borrowing of more money to invest in risky assets.
Efficient Frontier has list of all the optimal portfolio which has highest expected return for a given level or risk as explained in Markowitz Portfolio Theory. This portfolio will have list of stocks with negative correlation so that the risk gets diversified and decreased without affecting the expected returns.
For example, an investor who is less aggressive and want to go for a portfolio with standard deviation of 1%. Given that expected return on the market is 20% and risk free rate is 6% and standard deviation of market is 2 %. Calculate expected return of this portfolio with standard deviation of 1%
- Rp = 6% + 1% [20% – 6%]/2%
- Rp = 6% + [14%/2%] = 13%
With above same example, let’s say the investor go for a portfolio standard deviation of 2% in place of 1%. His expected return on this portfolio would be equal to
6% + 2% * [14%/2%] = 20%
Hence more the risk, more is the expected return.