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Capital market theory ASSUMPTIONS OF CAPM MODEL

The CAP-model is a ceteris paribus model. It is only valid within a special set of assumptions. They are: Investors are risk averse individuals who maximize the expected utility of their end of period wealth. Implication: The model is a one period model. Investors have homogenous expectations (beliefs) about asset returns. Implication: all investors perceive identical opportunity sets. This is, everyone have the same information at the same time. Asset returns are distributed by the normal distribution. There exists a risk free asset and investors may borrow or lend unlimited amounts of this asset at a constant rate: the risk free rate (k f). There is a definite number of assets and their quantities are fixed within the one period world. All assets are perfectly divisible and priced in a perfectly competitive marked. Implication: e.g. human capital is non-existing (it is not divisible and it cant be owned as an asset). Asset markets are frictionless and information is costless and simultaneously available to all investors. Implication: the borrowing rate equals the lending rate. There are no market imperfections such as taxes, regulations, or restrictions on short selling.

Capital Market Line and the Efficient Frontier


the efficient frontier is trying to do is determine the best possible combination of assets in a portfolio that maximises the expected level of returns for a given level of risk (as defined by volatility / standard deviation). In effect the efficient frontier gives a very formal relationship between risk and returns. Any portfolio that is below the efficient frontier line is deemed to be suboptimal this is quite intuitive as any point below will offer the same return for greater risk or same risk and less return. This leads to 2 formal definitions: 1) Maximise expected return for a given level of volatility

2) Minimise volatility for a given level of returns The set of optimal portfolios that we get from all the possible combinations of portfolios in the riskreturn is known as the efficient frontier. You can see a very clear illustration below where the lighter pinkish area is the set of all possible portfolios and the dark red line is the actual efficient frontier.

Efficient Frontier

Investors can make a choice of how they allocate funds between the risk free asset and the risky portfolio. This can range from all assets in the risk free asset to all (or more than all with leverage) in the risky portfolio. When we plot this in a graphical fashion we get a linear line with mean on the Y axis and the volatility on the x axis. Note that the line is linear as the risk free asset has no volatility. The important point to take away here is that each risky portfolio will have its own capital allocation line. The capital allocation line that lies at a tangent to the efficient frontier and is the highest possible line is known as the Capital Market line (because it is the market portfolio). Given the mean-variance criterion all investors will hold their portfolio in the same weights as the market portfolio (and hence lie on the capital market line). The CML is derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the expected return equals the risk-free rate of return. The CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk-free asset in the portfolio. The capital asset pricing model (CAPM) demonstrates that the market portfolio is essentially the efficient frontier. This is achieved visually through the security market line (SML).

Limitations of Capital Asset Pricing Model in Capital Markets

The Capital Asset Pricing Model (CAPM) states that it uses various assumptions about markets and investment behavior to predict the rate of return of an asset for a systematic risk. However, there are many flaws with the valuation model. Different investors require different required rate of return,there are no transaction costs or no taxes, holding period varies from one investor to another and borrowing rate is not equal as lending rate and many others. CAPM fails to act as an efficient valuation model in reality because the model works on a generalized principle rather than breaking it apart for different kind of investments.

The beta coefficient used in CAPM is basically a variance of an assets price to the market. Investors usually use beta for stocks to generate the required rate of return. The time value does matter when evaluating the required rate of return. The short-term and long-term rate would be affected so does the borrowing and lending cost. CAPM should consider the short-term rates as a risk-free rates rather than using long-term rates because the outlook for the country is negative and perhaps they may get downgraded again. Capital Asset Pricing Model- CAPM valuation model is not a suitable model to use in stock exchange or for any other investments for many reasons.

It is based on a number of unrealistic assumptions. It is difficult to test the validity. Betas do not remain stable over time. (Beta is a measure of a securitys risk).
Implifications of cml for investors

. Capital asset pricing model (CAPM) based on a number of assumptions. Given those assumptions, it provides a logical basis for measuring risk and linking risk and return Capital asset pricing model (CAPM) has the following implications,

Investors will always combine a risk free asset with a market portfolio of risky assets. They will invest in risky assets in proportion to their market value. Investors will be compensated only for that risk which they cannot diversify. This is the market related systematic risk. Beta which is a ratio of the covariance between the asset returns and the market returns divided by the market variance is the most appropriate measure of an assets risk. Investors can expect returns from their investment according to the risk. This implies a liner relationship between the assets expected return and its beta.

The concepts of risk and return as developed under capital asset pricing model (CAPM) have intuitive appeal and they are quite simple to understand. Financial managers use these concepts in a number of financial decisions making such as valuation of securities, cost of capital measurement, investment risk analysis excreta. However in spite of its intuitive appeal and simplicity capital asset pricing model (CAPM) suffers from a number of practical problems.

Assumptions of CAPM
There are many investors. They behave competitively (price takers). All investors are looking ahead over the same (one period) planning horizon. All investors have equal access to all securities. No taxes. No commissions. Each investor cares only about ErC and C. All investors have the same beliefs about the investment opportunities: rf , Er1,. . .,Ern, all i, and all correlations (homogeneous beliefs) for the n risky assets. Investors can borrow and lend at the one riskfree rate. Investors can short any asset, and hold any fraction of an asset
Aim to maximize economic utilities. Are rational and risk-averse. Are broadly diversified across a range of investments. Trade without transaction or taxation costs. Deal with securities that are all highly divisible into small parcels. Assume all information is available at the same time to all investors.

What is Portfolio Revision ? The art of changing the mix of securities in a portfolio is called as portfolio revision. The process of addition of more assets in an existing portfolio or changing the ratio of funds invested is called as portfolio revision. The sale and purchase of assets in an existing portfolio over a certain period of time to maximize returns and minimize risk is called as Portfolio revision. Need for Portfolio Revision An individual at certain point of time might feel the need to invest more. The need for portfolio revision arises when an individual has some additional money to invest. Change in investment goal also gives rise to revision in portfolio. Depending on the cash flow, an individual can modify his financial goal, eventually giving rise to changes in the portfolio i.e. portfolio revision. Financial market is subject to risks and uncertainty. An individual might sell off some of his assets owing to fluctuations in the financial market. Portfolio Revision Strategies There are two types of Portfolio Revision Strategies. 1. Active Revision Strategy Active Revision Strategy involves frequent changes in an existing portfolio over a certain period of time for maximum returns and minimum risks. Active Revision Strategy helps a portfolio manager to sell and purchase securities on a regular basis for portfolio revision. 2. Passive Revision Strategy Passive Revision Strategy involves rare changes in portfolio only under certain predetermined rules. These predefined rules are known as formula plans. According to passive revision strategy a portfolio manager can bring changes in the portfolio as per the formula plans only. What are Formula Plans ? Formula Plans are certain predefined rules and regulations deciding when and how much assets an individual can purchase or sell for portfolio revision. Securities can be purchased and sold only when there are changes or fluctuations in the financial market. Why Formula Plans ? Formula plans help an investor to make the best possible use of fluctuations in the financial market. One can purchase shares when the prices are less and sell off when market prices are higher.

With the help of Formula plans an investor can divide his funds into

aggressive and defensive portfolio and easily transfer funds from one portfolio to other. Aggressive Portfolio Aggressive Portfolio consists of funds that appreciate quickly and guarantee maximum returns to the investor. Defensive Portfolio Defensive portfolio consists of securities that do not fluctuate much and remain constant over a period of time. Formula plans facilitate an investor to transfer funds from aggressive to defensive portfolio and vice a versa.

Assumptions of Markowitz Theory The Modern Portfolio Theory of Markowitz is based on the following assump-tions: 1. Investors are rational and behave in a manner as to maximise their. utility with a given level of income or money. 2. Investors have free access to fair and correct information on the returns and risk. 3. The markets are efficient and absorb the information quickly and perfectly. 4. Investors are risk averse and try to minimise the risk and maximise return. 5. Investors base decisions on expected returns and variance or standard deviation of these returns from the mean. 6. Investors prefer higher returns to lower returns for a given level of risk. A portfolio of assets under