Capital mkt theory is used to dev a model for pricing risky assets. Assumptions: 1.

All investors are markwitz efficient investors who want to target points on the efficient frontier. The exact location on the eff frontier depnds on the investrs risk retunr utility functn. 2. nvestors can !orrow or lend any amnt of money " the risk free rate of return. t is always possi!l to lend money " the nominal risk free rate !y purchasin risk free securities like t!ills cds# !t it is not always poss!le to !orrw " thte risk fre rate. $. All investors hav homogeneous expectations. They estimate identical pro!a!ility distr for future rates of returns.this is not a realistic assumption %.all investors hav the same one period time horizon such as one month# & mnths or 1yr. e# the model is develpd for a single hypothetical period '. All investments are infinitely divisi!le. That means# it is possi!le to !uy or sell fractional shares of any asset portfolio. &. Ther r no taxes or transaction costs involved in !uying or selling some assets. (or eg# neither pension funds nor religious grps hav to pay taxes. Transaction costs on most financial instrumnents are less than 1) *ther is no inflation or ne chnage ininterest rates or inflation is fully anticipated.

+. Capital mkts are in e,uilli!rium situation. All assets are properly priced in line with their risk levels. The ma-or factor which is re,uired to develop the model is the risk free asset. .isk free asset is an asset with zero standard deviation. t has / correlation with all other risky assets. t provides risk free rate of return. t always lies on the vertical axis on the portfolio graph. C01rfi 2 34.f 5 67.f87.i967.i8:;7n918 f sd is zero# .f 2 67.f8 Therefore# cov 2 / .rfi2/ There are two assets: one is risk free and the risky asset <hen com!ined# the expected return from the portfolio <rf 2 weight of risk free 19<rf 2 weight of risky 67.port8 2 <rf7.rf8 = 719<rf8767.i88 67>2port8 2 wrf2 >rf2=71=<rf82 >i2 = 2<rf719<rf8C01rfi 271=<rf82 >i2 67> port 82 71=<rf8 >i There is a linear relationship !etween portfolio standard deviation and standard deviation of risky assets. Total risk of market portfolio consists of unsystematic risk and systematic risk.

?nsystematic risk is the uni,ue risk of an individual asset and can !e eliminated through diversification. The total risk of the market portfolio can !e reduced !y adding securities in the portfolio. As the num!er of securities increases# total risk decreases. @ut systematic risk cannot !e diversified away and it is caused !y various macroeconomic varia!les such as varia!ility in the money supply# interest rate volatility# varia!ility in the industrial productions# varia!ility in corporate earnings and cash flows. CAAB is used to determine the expected or re,uired rate of return on a risky asset. <hether an asset is overpriced or underpriced or properly valued can !e determined using CAAB and Cecurity Barket Dine. 67.i8 2 .f =E7.m9.f8 Cystematic risk of a risky asset is its covariance with the market portfolio E 2 covim;>2m >i2 7>i;>m8 x 7co vim;>i>m8 covim 2 37m 5 m!ar87 5 i!ar8;7n918 Any investor can choose any com!ination of the risk free asset and risky asset along the line .(.A. t will give the

higher return than any point !elow the point A on the efficient frontier. The portfolio possi!ilities along the line .(.@ will provide higher return than any portfolio along the line .(.A. 7 f we draw another line which will !e tangent to efficient frontier# it will provide greater return8 This tangent point B# will provide the highest portfolio possi!ilities for the investors which will provide the highest return. This line is called Capital Barket Dine. 6very investor will want to invest in portfolio B which leads all investors to invest at this point. f the investor wants to invest !eyond the point B# he will take higher risk to get higher return. f an investor add leverage to the portfolio !y !orrowing money at the risk free rate and investing in the risky portfolio at B# what would !e the return and riskF (or eg# if an investor want to !orrow an amount e,ual to '/) of his wealth# the effect on expected return and risk for his portfolio would !e: 67.prt8 2 <rf x .fr = 719<rf867.i8 2 9 /.' .fr =71979/.'8867.i8 2 9/.' .fr =1.'67.i8 The gross return increases !y '/) !ut the investor must pay the interest from the !orrowed money. The the .fr is &) and 67.i8 on the risky asset is 12) 2 1')

67>prt8 2 719 <rf8>i 271979o.'88 >i 2 1.' >i .isk and return !oth increases .isk averse investors lend part of their portfolio at the risk free rate and invest the reminder amount in the market portfolio. nvestors who prefer more risk try to !orrow money at the risk free rate and invest everything in the market portfolio. Co the decision to !orrow or lend to o!tain a point on the capital market line is a separate (inancing decision !ased on the risk preference. This separation of the investment and financing decision is referred to as the Ceparation Theorem. CBD leads all investors to invest in the B portfolio at tangent point which com!ines risk free asset and risky assets. ndividual investors differ in position on the CBD depending on risk preference.