Advanced Portfolio Management
ADMS 4501 – Winter 2012 – Lois King
Lecture 3 – Chapter 7 – Asset Pricing Models – Jan 19
Capital Market Theory: An Overview
- 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.
- For areas
o Background for capital market theory
o Developing the capital market line
o Risk, diversification and the market portfolio
o Investing with the CML: an example
Background to Capital Market Theory
o All investors are Markowitz efficient investors who want to target points on
the efficient frontier.
o Investors can borrow or lend any amount of money at the risk-free rate of
o All investors have homogeneous expectations; that is, they estimate
identical probability distributions for future rates of return.
o All investors have the same one-period time horizon such as one-month,
six months or one year.
o All investments are infinitely divisible, which means that it is possible to
buy or sell fractional shares of any asset or portfolio.
o There are no taxes or transaction costs involved in buying or selling
o There is no inflation or any change in interest rates, or inflation is fully
o Capital markets are in equilibrium, implying that all investments are
properly priced in line with their risk levels.
- Development of the Theory
o 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.
Developing the Capital Market Line
- Covariance with a risk-free asset
o Because the returns for the risk free asset are certain, which means that
the covariance between the risk-free asset and any risky asset or portfolio
will always be zero? o Similarly, the correlation between any risky asset and the risk-free asset
would be zero too.
- The capital market line
o This relationship holds for every combination of the risk-free asset with
any collection of risky assets.
o 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.
Risk, Diversification and the Market Portfolio
- Systematic risk
o Only systematic risk remains in the market portfolio.
o Variability in all risky assets caused by macroeconomic variables.
Variability in growth of money supply.
Interest rate volatility.
Variability in factors like (1) industrial production (2) corporate
earnings (3) cash flow.
o Can be measured by standard deviation of returns and can change over
- A risk measure of the CML
o The Markowitz portfolio model considers the average covariance with all
o The only important consideration is the asset’s covariance with the market
Conceptual Development of the CAPM
- The existence of a risk-free asset resulted in deriving a capital market line (CML)
that became the relevant frontier.
- However, CML cannot be used to measure the expected return on an individual
- For individual asset (or any portfolio), the relevant risk measure is the asset’s
covariance with the market portfolio.
The Security Market Line (SML)
- The SML is a graphical form of the CAPM.
- Shows the relationship between the expected or required rate