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(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

 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