Capital Market Theory. Outline  Overview of Capital Market Theory  Assumptions of Capital Market Theory  Development of Capital Market Theory  Risk-Return.

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Presentation transcript:

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  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

 Expected Return of a Portfolio that contains a risk-free asset and a risky asset E(R p ) = w x E(r A ) + (1-w) x r f  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

 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