Capital Market Theory

30/10/2021
9:30-10:45
Introduction:
 A risk-averse and rational investor would like to

maximize the expected return for a given risk or would

like to minimize the risk for a given expected return.
 Portfolio theory provides a normative approach for the

analysis and identification of such risk-minimizing

portfolios.
 Using Markowitz or Sharpe single-index model, an

investor can identify the set of portfolios that maximize

expected return at each level of risk.
 The set of efficient portfolios thus obtained is the

efficient frontier.
 Every investor, in analyzing the risk and return of

individual securities, should choose a portfolio, which

lies on the efficient frontier.
 One important implication of the normative approach

provided by the portfolio theory is pricing of financial

assets.
 If all the investors act in a manner that maximizes

expected return at a given level of risk, what are the

results of this aggregate behavior in terms of the
relationship between risk and expected return?
 Capital market theory relates to the pricing of financial

assets and the equilibrium relationship between risk and

expected return that results from the aggregate
behavior of investors seeking to maximize expected
return.
  The capital market theory is actually an extension of the
portfolio theory, and it makes an attempt to develop a
model to price the risky assets.
 In fact, the final outcome of the process, i.e., the capital
asset pricing model determines the required rate of
return for any risky asset.

Markowitz Model and Efficiency Frontier:

 The Markowitz model of portfolio analysis generates an

efficient frontier, which is a set of efficient portfolios.

 A portfolio is said to be efficient if it offers the maximum

expected return for a given level of risk or if it offers the

minimum risk for a given level of expected return.
 The concept of efficient portfolio can be illustrated with

an example.
 Suppose you have three portfolios A, B and C. Risk-

return characteristics of these portfolios are:

Portfolio Expected Return Standard Deviation

E(𝑟 )% E(𝜎 )%
A 8 12
B 8 18
C 10 18

 If we have to choose between portfolios A and B, we

would choose A since it gives us the same return as B,
but has a lower risk than B.
 That is, portfolio A dominates B and is considered to be
superior or efficient.
 In the same way, portfolio C dominates B and is
considered to be efficient.
 If we can identify all such efficient portfolios and plot
them, we will get what is called the efficient frontier.
 Efficient frontier is a set of efficient portfolios.
 Portfolios lying above the efficient frontier are desirable
but are not available.
 Portfolios below the efficient frontier are attainable but
not desirable since they are dominated by efficient
portfolios.
 Therefore, efficient frontier is also a frontier
demarcating the possible from impossible portfolios.
 Markowitz devised an ingenious computational model
to trace the efficient frontier and to identify the
portfolios that comprise the efficient frontier.
 He used the technique of quadratic programming for
calculations.
 He assumed that one could deal with N securities or
fewer.
 Using the expected return, variances and all pairwise
covariances among securities being considered for
inclusion in the portfolio, he was able to calculate risk
 and return for any portfolio comprising some or all of
securities.
 In particular, for any specific value of expected return,
using the programming calculations he determined the
least risk portfolio.
 With another value of expected return, a similar
procedure again yields the minimum risk combination.
 By tracing this process, the efficient frontier is derived.

Assumptions of Markowitz Model

As with any model building exercise, the Markowitz portfolio
theory is also based on a few assumptions as:
(i). Investors are risk-averse and thus have a preference
for expected return and dislike for risk. This is the general
behavior of a rational investor. An investor would like to
get the highest return possible for a given risk or would
like minimizing the risk for a given expected rate of
return.
(ii). Investors act as if they make investment decisions on
the basis of the expected return and the variance (or
standard deviation) about security return distributions.
That is, investors measure their preferences and dislike
for investments through the expected return and
variances (or standard deviations) about security return.

Evolution of Capital Asset Pricing Model (CAPM):

 The CAPM was developed in the mid-1960s. The model

has generally been attributed to William Sharpe, but

John Lintner and Jan Mossin also made similar
independent derivations.
  Consequently, the model is often referred to as Sharpe-
Lintner-Mossin (SLM) Capital Asset Pricing Model.
 The CAPM explains the relationship that should exist
between the securities’ expected returns and their risks
in terms of the means and standard deviations about
security returns.
 Because of this focus on the mean and standard
deviation, the CAPM is a direct extension of the
portfolio models developed by Markowitz and Sharpe.
 Although the model has been extensively examined,
modified and extended in the literature, the original
version of the CAPM still remains the central theme in
the Capital Market Theory as well as in the current
practices of investment management.
 Using a set of simplifying assumptions, the CAPM is an
equation that expresses the equilibrium relationship
between a security’s (or portfolio’s) expected return and
its systematic risk.
 Because the CAPM is relatively a simple model, it has
been employed in a wide variety of academic and
institutional applications such as measuring portfolio
performance, testing of market efficiency, identifying
under and overvalued securities, determining consensus
price of risk implicit in the current market prices and
capital budgeting.

Assumptions of CAPM
 The capital market theory is built on the basis of

Markowitz’s portfolio model. This theory is based on

certain assumptions as:
 (a). All the investors are considered to be efficient
investors who like to position themselves on the efficient
frontier. Their exact location on the efficient frontier,
however, depends on their risk-return utility function.
(b). Investors are free to borrow or lend any amount of
money at the Risk-Free Rate of Return (𝑟 ).
(c). All investors are expected to have homogeneous
expectations, i.e., their future rates of return have
identical probability distributions.
(d). All investors have same investment time horizons.
(e). All investments are assumed to be infinitely divisible
making it possible to even buy or sell fractional shares of
any portfolio.
(f). The process of buying or selling of assets does not
involve any transaction costs. For example, holders of
pension funds and even religious groups do not have to
pay taxes and further it has been found out that the
transaction cost on many financial instruments that are
traded by most of the financial institutions are less than
one percent.
(g). It is assumed that the inflation rate is fully
anticipated, or in other situations it may totally be absent
thus resulting in no changes in the tax rate.
(h). Another assumption of the theory is the equilibrium
in the capital markets, that is, all the investments are
correctly priced on par with their risk levels.

 It might sound unrealistic; for instance, it may be

possible to lend money at a risk-free rate by buying the
risk-free securities, say, the treasury bills, but it may not
be possible to borrow money at the risk-free rate while
 stating some of the assumptions and it should be borne
in mind that even by relaxing some of these
assumptions, the model does not change much.

 As CAPM is an extension of the Markowitz portfolio

theory, the assumptions on which Markowitz portfolio
theory is based are also applicable to CAPM.

Assumptions common to both the Markowitz Model and the

CAPM
(a). Investors are risk-averse, and are 'expected utility'
maximizers.
(b). Investors choose portfolios on the basis of their
expected mean and variance of return.

Additional assumptions for CAPM

(a). Borrowing and lending at the risk-free rate are
unrestricted.
(b). All investments are perfectly divisible.
(c). All investors have uniform, single period investment
horizon; and expectations regarding means, variances
and covariances of security returns are homogeneous.
(d). There are no imperfections in the market.
(e). Capital markets are in equilibrium.

Standard Deviation vs. Beta

 Investments are risky because returns cannot be

comprehended. The return that an investment is

expected to fetch probably will not be the same as that
actually obtained. Therefore, variation exists around the
expected return.
  In investment analysis, it is necessary to quantify the risk
usually employing the following two measures:
(i). The Standard Deviation (or Variance)
(ii). The Beta
 Now, a rational, risk-averse investor views variance as

the appropriate risk measure if he holds only one

security. In that case, the only security he holds
becomes his portfolio. So, the return on his security
becomes a return on the portfolio. Variation around the
expected return, statistically can be measured by
standard deviation or variance.
 On the other hand, for one holding multiple assets, the

contribution of any one of the assets to the riskiness of

the portfolio is its systematic or non-diversifiable risk.
 Thus, for a well-diversified portfolio, the appropriate

measure of risk would be beta, for, in that case the

returns on assets move relative to the returns on the
market portfolio. Beta in fact absorbs the risk which
cannot be diversified.
 By effective diversification, asset specific risks are

eliminated, and the measure of risk in such case is beta.

It is an indication as to how the individual asset is
contributing to the total risk of a portfolio.

Risk-free Assets:
 A risky asset is one which gives uncertain future returns.

This uncertainty can be measured by the variance or the

standard deviation of the expected future returns.
 A risk-free asset is one whose expected risk is fully

certain and thus the standard deviation of such

expected returns comes to zero, i.e., 𝜎 = 0. Further, it is
 to be remembered that the rate of return earned on
such assets should be the risk-free rate of return ( 𝑟 ).

Covariance of a Risk-Free Asset with a Risky Asset

The covariance between the returns of two assets, A and B
can be calculated as follows.

(𝑅 − E(𝑅 ) (𝑅 − E(𝑅 )
𝜎 =
𝑛

 The uncertainty for a risk-free asset is known, 𝜎 = 0,

which implies that 𝑟 = E(𝑟 ) for all the periods. Thus, 𝑟 -
E(𝑟 ) = 0, which further leads to the fact that the product
of any other expressions with this expression will be
zero.
 This will result in the covariance of the risk-free asset
with any risky asset or portfolio to be also zero.
 Similarly, the correlation between any risky asset and
risk-free asset, f, will be zero as 𝜌 , =
,

Combining a Risk-Free Asset with a Risky Portfolio

 What happens to risky assets that exist on the

Markowitz efficient frontier when they are combined

with risk-free assets, and at the same time what
happens to their average rates of return and standard
deviations.
 The expected return of the above portfolio can be

written as:

E(𝑟 ) = 𝑊 𝑟 + 1 − 𝑊 𝐸(𝑟 )
Where,
𝑊 = the proportion of the portfolio invested in the risk-free
assets
𝐸(𝑟 ) = expected return on risky portfolio A.

The expected variance for two asset portfolios can be written

as:

𝐸(𝜎 ) = 𝑊 𝜎 + 𝑊 𝜎 + 2𝑊 𝑊 𝜌 𝜎 𝜎

Now on substituting the risk-free asset for security 1 and

risky asset for security 2, we get

𝐸(𝜎 ) = 𝑊 𝜎 + 1 − 𝑊 𝜎 + 2𝑊 (1 − 𝑊 )𝜌 𝜎 𝜎

For a risk-free asset, 𝜎 = 0 and 𝜌 , = 0, because

correlation between risky asset 'A' and risk free asset 'f' is
zero.

𝐸(𝜎 ) = 1 − 𝑊 𝜎

E(𝜎 ) = (1-𝑊 )𝜎

 So, we can say that for any portfolio that combines a

risk-free asset with any risky asset, the standard
deviation is the linear proportion of the standard
deviation of the risky asset portfolio.

Risk-Return Possibilities with Leverage

  An investor will always want to increase his expected
returns. Say, he is situated at a certain point ‘k’, on the
efficient frontier, he will want to go beyond that point,
i.e., increase his expected return, by accepting higher
degree of risk.
 One way of doing so may be by investing in one of the
risky portfolios on the efficient frontier beyond the point
‘k’.
 Another way is to add leverage to the portfolio by
resorting to borrowing money at a risk-free rate and use
the proceeds to invest in a risky asset portfolio at point
‘k’.
 If a person has borrowed an amount which is 50 percent
of his original wealth, the effect of this on the expected
return for the portfolio would be:

E(𝑟 ) = 𝑊 𝑟 + 1 − 𝑊 𝐸(𝑟 )

E(𝑟 ) = -0.50 𝑟 + [1 − (−0.50)] 𝐸(𝑟 )

E(𝑟 ) = -0.50 𝑟 + 1.50 𝐸(𝑟 )

Thus, we see that the return increases in a linear fashion

along the line of risk-free rate (𝑟 ) and ‘k’.
Now, suppose E(𝑟 ) = 0.07 And E(𝑟 ) = 0.13
E(𝑟 ) = (-0.50*0.07)+(1.5*0.13)=0.16 (or) 16%

Similar is the effect of standard deviation of the leveraged

portfolio.

E(𝜎 ) = 1 − 𝑊 𝜎
E(𝜎 ) = [1 - (-0.5)] 𝜎 = 1.50𝜎

Lending and Borrowing at the Riskless Rate

The consideration of a riskless asset alters the efficient
frontier considerably. There shall be borrowing and lending
at the risk-less rate 𝑟 and investing in the risky portfolios.
The following is the efficient frontier, in terms of expected
return E(r), and standard deviation (σ), along with the riskless
asset 'f' and three risky portfolios, A, B and M.

 Since the riskless asset f has no risk, (i.e., 𝜎 = 0), its E(r)
and σ plot on the zero-risk, vertical axis at the point 𝑟 ,
represents the expected rate of return on the riskless
asset 'f'.
 With the riskless asset 'f' and the ability to borrow or
lend (invest) at risk-free rate 𝑟 , it is now possible to form
portfolios that have risky assets as well as the risk-free
assets within them.
 Furthermore, all combinations of any risky portfolio and
the riskless asset will lie along a straight line connecting
their E(r), σ plots.
 The portfolios containing 'f' and the risky portfolio A will
lie along the line segment 𝑟 as shown in the figure.
 Similarly, combination of 'f' with either portfolio B or
portfolio M will lie along segments 𝑟 and 𝑟 ,
respectively.
 Therefore, combining any risky portfolio with a riskless
asset produces a linear relationship between their
respective E(r), σ points.

 Borrowing and Lending at the riskless rate 𝑟 and

investing in the risky portfolio M:
Lending Portfolios:
 Combinations of a risky portfolio with the riskless asset

are generally referred to as lending portfolios, since

some of the investment is invested or lent at the riskless
rate 𝑟 , That is, 1 > 𝑊 > 0.

 The portfolio expected return for any portfolio 'i' that

combines 'f' and 'M' is
E(𝑟 ) = 𝑊 𝑟 + 1 − 𝑊 𝐸(𝑟 )
Where,
𝑊 = The percentage of the portfolio invested in the
riskless security 'f'
1 − 𝑊 = The percentage of the portfolio invested in the
risky portfolio 'M'

 The portfolio variance for portfolio 'i' is:

 𝜎 = 𝑊 𝜎 + 1 − 𝑊 𝜎 + 2𝑊 (1 − 𝑊 )𝜎 ,
Where,
𝜎 = Variance of risk-free asset
𝜎 = Variance of portfolio M
𝜎 , = Covariance between f and M

 As 𝜎 = 0 since it is a risk-free asset and 𝜎 , = 0, because

covariance between risky asset 'M' and risk free asset 'f'
is zero.
σ = 1−𝑊 𝜎

𝜎 = (1-𝑊 )𝜎

Suppose the risk-free rate, 𝑟 , is 8% and expected return on

the risky portfolio, 𝑟 , is 20% with a standard deviation of
25%. If an investor would like to invest 20% of his portfolio in
the risk-free asset, f, and the balance in the risky portfolio, M,
then the risk-return characteristics of the portfolio will be:

E(𝑟 ) = 𝑊 𝑟 + 1 − 𝑊 𝐸(𝑟 )
E(𝑟 ) = (0.20*8)+((1-0.20)*20)=17.6%

Standard deviation of expected return of the portfolio:

𝜎 = (1-𝑊 )𝜎
𝜎 = (1-0.2)*25=20%

 The following are portfolio expected returns and

standard deviations for various combinations of
lending at 𝑟 and risky portfolio M:
 𝑊 0.00 0.25 0.50 0.75 1.00
(1-𝑊 ) 1.00 0.75 0.50 0.25 0.00
E(𝑟 ) 20.00 17.00 14.00 11.00 8.00
𝜎i 25.00 18.75 12.50 6.25 0.00

Borrowing Portfolios:
 The investors cannot only lend or invest at the risk-free

rate 𝑟 , but they can borrow unlimited amount at the

same risk-free rate 𝑟 . That is, the proportion of funds
invested in the risk-free asset 𝑊 , becomes negative.
 When the percentage of portfolio invested in riskless

security 'f' is negative, that is, 𝑊 < 0, the resulting

portfolio is referred to as the borrowing portfolio.
 This is because, additional funds are borrowed at 𝑟 and

invested in the risky portfolio.

 This borrowing portfolio would be analogous to a short

sale of riskless security 'f'.

 The portfolio expected return for a borrowing portfolio i

is:
E(𝑟 ) = −𝑊 𝑟 + 1 + 𝑊 𝐸(𝑟 )

 As 𝜎 = 0 since it is a risk-free asset and 𝜎 , = 0, because

covariance between risky asset 'M' and risk free asset 'f'
is zero.
σ = 1+𝑊 𝜎

𝜎 = (1+𝑊 )𝜎
Suppose the risk-free rate, 𝑟 , is 8% and expected return on
the risky portfolio, 𝑟 , is 20% with a standard deviation of
25%. If an investor would like to borrow 20% of his portfolio
and invests in the risky portfolio, M, then the risk-return
characteristics of the portfolio will be:

E(𝑟 ) = −𝑊 𝑟 + 1 + 𝑊 𝐸(𝑟 )
E(𝑟 ) = (-0.20*8)+(1+0.20)*20=22.4%

Standard deviation of expected return of the portfolio:

𝜎 = (1+𝑊 )𝜎
𝜎 = (1+0.20)*25=30%

 The following are portfolio expected returns and

standard deviations for various combinations of
borrowing at 𝑟 and risky portfolio M:

𝑊 0.00 -0.25 -0.50 -0.70 -1.00

(1-𝑊 ) 1.00 1.25 1.50 1.70 2.00
E(𝑟 ) 20.00 23.00 26.00 29.00 32.00
𝜎i 25.00 31.25 37.50 43.75 50.00

 An important implication of introducing riskless rate

of lending and borrowing is the transformation of the
efficient frontier.
 With the introduction of 𝑟 , the efficient frontier is
transformed into a linear form.
 Furthermore, as long as 𝐸(𝑟 ) > 𝑟 , investors can
continually increase expected return and risk by
 borrowing increasing amounts at 𝑟 and investing the
borrowed proceeds in portfolio M.

The Dominant Portfolio M:

 By borrowing and lending at the riskless rate 𝑟 ,

investors can alter the risk/expected return profile of

any efficient portfolio to meet personal preferences for
risk and expected return.
 Regardless of whether investors want to borrow or lend,

portfolio M is the best efficient portfolio.

 This is because investors can invest in portfolio M and

then borrow or lend at 𝑟 to suit their preference.

 That is, by borrowing and lending at 𝑟 , in conjunction

with investing in portfolio M, they can create portfolio

combinations along the line 𝑟 M, in such a way that for a
given level of risk it is possible to find a combination of
M and risk-free borrowing/lending which offers a return
that is higher than the one available for a portfolio on
the efficient frontier.
 With the introduction of unlimited risk-free borrowing
and lending, it is possible to construct a portfolio
consisting of M and risk-free lending or/and borrowing.
 The portfolios on the line 𝑟 M always dominate the
portfolios on the efficient frontier.
 Because of this dominance, all investors should choose
efficient portfolio M in conjunction with their
preferences for lending or borrowing at the risk-free
rate 𝑟 .
 Graphically, portfolio M represents the tangent between
a ray drawn from the intercept 𝑟 , to the efficient
frontier.
 This tangent drawn from 𝑟 to M has the greatest slope
for any line drawn from 𝑟 to the efficient set of risky
portfolio.
  That is, point M is the efficient portfolio that maximizes
the value of [E(r)-𝑟 ]/σ, risk premium.
 Thus, portfolios along this line will maximize E(r) at their
respective σ levels, when compared to portfolios along
lower rays drawn from rf to any other portfolio along
the efficient frontier.

The Separation Theorem:

 With the inclusion of the riskless asset in the investment

opportunity set, all investors should choose the same

portfolio M, because that risky portfolio, in conjunction
with borrowing or lending at 𝑟 , will enable them to
reach the highest level of expected return for their level
of desired risk. This result is of critical importance to the
development of the CAPM.
 According to the portfolio theory, each investor should

choose an appropriate portfolio along the efficient

frontier. The particular portfolio chosen may or may not
involve borrowing or the use of leveraged, or short
positions.
 The investment decision (to choose efficient portfolio

from among others) and the financing decision (whether

or not their portfolio involved borrowing, or short sales)
are determined simultaneously in accordance with the
risk level, identified by the investor at an acceptable
level.
 Therefore, the investment decision is the same for all

investors as everyone should choose to invest in

portfolio M.
  The financing decision, or how much to borrow or lend,
will vary from investor to investor according to
individual preferences for risk and expected return.
 That is, the individual investor will invest in portfolio M
and then borrow or lend at 𝑟 in an amount such that
their utility function, as represented by their
indifference curves, is just a tangent to the line 𝑟 𝑀.

Personal Preferences for Risk and Expected Return:

 The investor A’s optimal portfolio calls for lending;

whereas investor B’s optimal portfolio calls for
borrowing. This analysis suggests that both types of
investors should hold identical risky portfolios.
 Desired risk levels are then achieved through combining
portfolio M with lending or borrowing and the
separation of investing and financing decisions is called
the separation theorem and provides a fundamental
result for the development of the CAPM.
Suppose there are two investors A and B. The objective of
investor ‘A’ is to earn a return of 25% and assume the
relevant risk. On the other hand, the objective of investor B is
to limit his risk to a variance of 400(%)2. Assume the risk-free
rate, 𝑟 , is 8% and expected return on the risky portfolio, 𝑟 ,
is 20% with a standard deviation of 25%. The financing
decisions of A and B are determined as follows:

Investor A:
E(𝑟 ) = 𝑊 𝑟 + 1 − 𝑊 𝐸(𝑟 )

Targeted E(𝑟 ) for A is 25%

25 = (𝑊 *8)+( 1 − 𝑊 *20)
25 = 8𝑊 + 20 - 20𝑊
-12𝑊 = 5
𝑊 = -5/12=-0.4167 (or) -41.67%

That is, A should borrow 41.67% of his portfolio at the rate of

8% and invest in
the market portfolio M to obtain the expected return of 25%.

Standard deviation of expected return of the portfolio:

𝜎 = (1-𝑊 )𝜎
𝜎 = (1-(-0.4167))*25=35.4175%

Investor B:
Targeted risk σ = 400
𝜎 = 20
20 = (1-𝑊 )25
1-𝑊 = 20/25
𝑊 = 1-(20/25)=0.2

That is, B should invest 20% of this portfolio in risk-free

asset 'f' to limit his risk at 𝜎 = 20%.

Expected return will be

E(𝑟 ) = 𝑊 𝑟 + 1 − 𝑊 𝐸(𝑟 )
E(𝑟 ) = (0.20*8)+(0.80*20)=17.6%

The Capital Market Line:

 With the ability to borrow and lend at the risk-free rate

𝑟 , in conjunction with an investment in market portfolio

M, the old curved efficient frontier is transformed into a

new efficient frontier, which is a line passing from 𝑟 ,
through market portfolio M.
 This new linear efficient frontier is called the Capital

Market Line, or simply the CML.

 An inspection of the figure indicates that all portfolios

lying along the CML will dominate, in terms of E(r) and

σ, the portfolios along the previous curved efficient
frontier.
 The Capital Market Line not only represents the new
efficient frontier, but it also expresses the equilibrium
pricing relationship between E(r) and σ for all efficient
portfolios lying along the line.
 Since the equation for any line can be expressed as y = a

+ bx, where 'a' represents the vertical intercept and 'b'

represents the slope of the line, the pricing relationship
given by the CML can be easily determined.
 Assuming a = rf and b = [E(rΜ)- rf]/σΜ, the CML

relationship for any efficient portfolio 'i' is provided in

equation,
E(ri) = rf+{[E(rΜ)-rf]/σΜ}σi
 In other words, the expected return on any efficient

portfolio i, E(ri), is the sum of two components:

(1) the return on the risk-free investment rf, and
(2) a risk premium, {[E(rΜ)-rf]/σΜ}σi that is proportional to
the portfolio’s σi.
 The slope of the CML [E(rΜ) - rf]/σΜ is called the market
price of risk, and this component is the same for all
portfolios lying along the CML.
 Thus, the factor that distinguishes the expected returns
among CML portfolios is the magnitude of the risk, σi.
 The greater the σi, the greater the risk premium and the
expected return on the portfolio.

 Assume that the expected return on the market

portfolio M, rΜ, is 20%, with a standard deviation, σΜ, of
25%. If the risk-free rate, rf is 8%, the slope of the CML
would be:
(20-8)/25=0.48
 The slope of the CML shows the equilibrium price of risk

in the market. In other words, a risk premium of 0.48%

indicates that the market demands this amount of
return for each percentage increase in the portfolio’s
risk.
 Now, the CML’s intercept would be r f = 8%.

 Therefore, the CML equation is: E(ri) = 8 + 0.48σi

 It is important to recognize that the CML pricing holds

only for efficient portfolio that lies along its line. That is,
only the most efficient, in terms of risk-reducing
potential, portfolios that are constructed of
combinations of the risk-free asset 'f' and market
portfolio 'M' lie along the CML.
 All individual securities and inefficient portfolios lie
under the curve.
  For the efficient set of portfolios along the CML, their
total risk, as measured by σi, represents their systematic
risk, since all unsystematic risks have been diversified.
 That is, the efficient frontier not only produces the set
of optimal portfolios in terms of risk and expected
returns, but it also represents the most efficient set of
diversified portfolios at different levels of expected
returns.
 Thus, the CML not only represents portfolios that are
efficient in a risk/expected return sense, but it also
represents zero unsystematic risk portfolios.
 Since total risk, σi, is the sum of systematic and
unsystematic risk, a portfolio that is well-diversified has
its total risk equal to its systematic risk.
 Therefore, for well-diversified efficient portfolios that lie
along CML, their risk, σi, can be thought of as either total
risk or systematic risk.
 Thus, the CML states that the appropriate measure of
risk that is to be priced for these efficient portfolios is
the level of systematic risk present in these portfolios.

The Capital Asset Pricing Model (CAPM):

 The CML is important in describing the equilibrium

relationship between expected return and risk for

efficient portfolios that contain no unsystematic risk.
 It is not, however, the appropriate equation for

explaining the theoretical relationship that should exist

between expected return and risk for securities and
portfolios in general.
 This gives rise to two important questions:
 (1) What is the appropriate measure of risk that investors
should use to evaluate the expected returns for all
securities and portfolios, efficient or inefficient?
(2) What is the equilibrium relationship that should exist
between the expected return on a security and its
relevant measure of risk?

The formula for the variance of a portfolio of 'n' securities:

𝜎 = 𝑊𝑊𝜎

When portfolios are equally weighted, that is, when Wi = 1/n,

the expected level of portfolio risk can be expressed as:

1
𝐸(𝜎 ) = [𝐸(𝜎 ) − 𝐸 𝜎 ] + 𝐸(𝜎 )
𝑛

Where,
𝐸(𝜎 ) = Average variance of an individual securities included
in the portfolio
𝐸(𝜎 ) = Average pair-wise covariance between securities in
the portfolio

 If 'n' is sufficiently large, the impact of a single security’s

variance on the overall risk of the portfolio is negligible.
 Furthermore, since the investor should hold the market
portfolio M, 'n' is very large and the impact of a single
security’s variance on the total risk of the market
portfolio is negligible.
 The second, and more important, impact of a security
on the expected risk of an investor’s portfolio is through
the average covariance element, 𝐸(𝜎 ).
 Whenever a security is added to the portfolio, it affects
the average covariance component through its
relationship with all the other (n-1) securities in the
portfolio.
 If the covariance of the new security is greater (less)
than the existing average covariance among the
securities in the portfolio, the security can significantly
raise (lower) the overall portfolio risk.
 Therefore, effective diversification involves adding new
securities whose returns have low-levels of covariance
or correlation with the returns of those securities
already included in the portfolio.
 Thus securities whose returns have low or even negative
levels of covariance with the returns of the other
securities will be in great demand and are sought by
investors who choose to diversify their holdings.
 It can be concluded that a security’s expected return
should be positively related to the level of covariance
between that security’s return and the return on the
investor’s personal portfolio. The greater the
covariance, the higher the required return.
 Since all investors should hold the same portfolio,
market portfolio M, the required return should be a
function of the covariance between the security’s return
and the market portfolio.
 The equilibrium relationship between securities’
expected returns and their covariances with the market
portfolio is called the Security Market Line (SML).
  The CAPM is the theoretical relationship that should
hold for all securities and portfolios, both efficient and
inefficient. In equilibrium, all securities and portfolios
[E(ri), 𝜎 ] plots should lie on the CAPM line.

Using the relationship y = a + bx and recognizing that (𝜎 )=

(𝜎 ), the CAPM is given by:

𝐸(𝑟 ) − 𝑟
𝐸(𝑟 ) = 𝑟 + 𝜎
𝜎

 It is important to recognize that since all investors can

and should diversify by holding market portfolio M, the
relevant measure of risk in the pricing of security
expected returns is the security’s systematic risk, as
measured by σiM.
  Thus, the CAPM says that unsystematic risk should not
be priced, since investors can and should diversify or
eliminate this portion.

Substituting β = in the CAPM relation,

𝐸(𝑟 ) = 𝑟 + 𝐸(𝑟 ) − 𝑟 𝛽

CAPM relationship in terms of Beta:

Security Market Line (SML):

 Security market line or market line is another way to a

perceive risk-return equilibrium relationship.

 With expected return on X-axis and β on Y-axis, if the

market portfolio is drawn and the line is extended to

risk-free rate of return, SML is obtained.
  It is a line which passes through risk-free return and
expected return of a market portfolio.

The equation of SML is:

𝐸 𝑟 = 𝑟 + 𝐸(𝑟 ) − 𝑟 𝛽

There are two instant interpretations of SML:

(i). Each asset may be viewed as a combination of risk-
free asset and market portfolio.
(ii). Under equilibrium, all the assets are plotted on the
SML i.e., all the assets, which are priced correctly, lie on
SML.

 The SML also describes whether a particular asset is

defensive or aggressive.
 As the beta of the market is one, it serves as a reference
to assess the assets.
  Assets for which beta is less than one are called
defensive assets and those with beta greater than one
are called aggressive assets.
 SML also explains whether a particular asset is
underpriced, overpriced or correctly priced.

Reconciling CML with SML:

 The characteristic capital market line actually represents

the expected returns of the efficient portfolios as a

function of their volatility which is measured by the
standard deviation of their returns whereas the security
market line represents the expected returns of the
individual asset as a function of its sensitivity to market
fluctuations.
 A rightly priced security will lie exactly on the security

market line.
 It is to be noted that all the efficient portfolios of the

CML lie on the SML, but the converse is not true.

 The equation of SML can be written as:

E(𝑅 ) = 𝑅 + 𝐸(𝑅 ) − 𝑅 𝛽
𝜎
𝐸(𝑅 ) = 𝑅 + 𝐸(𝑅 ) − 𝑅
𝜎
𝜌 𝜎 𝜎
𝐸(𝑅 ) = 𝑅 + 𝐸(𝑅 ) − 𝑅
𝜎

If the portfolio P is on CML, then 𝜌 =1 (perfectly

positively correlated).

𝜎
𝐸(𝑅 ) = 𝑅 + 𝐸(𝑅 ) − 𝑅
𝜎
 ( )
E(𝑅 ) = 𝑅 + 𝜎 which is CML.

Application of CML and CAPM:

 The CML depicts the linear relationship between

expected return and total risk of all efficient

portfolios; while the SML depicts the linear
relationship between expected return and systematic
risk of all individual securities and all portfolios.
 The CAPM is a general risk/expected return pricing

relationship for all assets whereas the CML is a

special case of the CAPM.
 The understanding of applications of the CAPM also

covers the application of the CML.

 There are a number of applications of ex-post SML in

security analysis and portfolio management. Among

these are (a) evaluating the performance of portfolio;
(b) tests of asset pricing theories; and (c) tests of
market efficiency.
 Ex-ante SML can be used to identify mispriced

securities. It represents the linear relationship

between the expected rates of return for securities
and their expected betas.

Performance Evaluation of Portfolios

 The performance of portfolio is frequently evaluated

based on the security market line criterion a large

positive alpha being taken as an indicator of superior
(above normal) performance and a large negative
alpha being taken as an indicator of inferior (below-
normal) performance.

Tests of Asset Pricing Theories

 The CAPM pricing model is given by the equation:
E(𝑅 ) = 𝑅 + 𝐸(𝑅 ) − 𝑅 𝛽
 Conceptually, all the variables in the equation are ex-

ante expectations of what investors believe will be the

values for E(𝑅 ), 𝑅 , 𝐸(𝑅 ) and 𝛽 over the coming relevant
investment horizon.
 However, since large-scale data for individual security

expectations do not exist, almost all empirical tests of

the CAPM have been conducted using ex post, realized
return data. That is, ex post data are assumed to be
suitable proxies for expectations.
 Generally, a two-step procedure is employed to test

the CAPM.
 In the first step, betas are estimated using the holding

period returns for securities and the market index.

The Single Index Model (Sharpe Single Index Model)
used for estimating the betas is:
r. = 𝛼 , +𝛽, 𝑟 , +𝜀,
Where,
𝑟 . = Return on security 'i' in time period 't'
𝑟 , = Return on the market index in time period 't'
α , = A constant, the portion of return on stock i that
is not related to the market return
𝜀 , = Error term, the portion of the security’s return
that is not captured by α and β .
 The second step tests whether or not the betas are

related to expected returns in the manner predicted

by the CAPM. The step involves the estimation of a
regression of the form,
r, =𝜏 , +𝜏 , 𝛽 +𝜀,
Where,
 𝑟 . = Realized return (Holding Period Yield) on
portfolio 'i' in period 't'
β , = Beta of portfolio 'i' in period 't'
𝜏 , & 𝜏 , = Regression parameters estimated in period
't'
𝜀 , = Error term from the regression
 By running the above regression over different

periods, it can be determined whether or not 𝜏 , and

𝜏 , conform to the CAPM theory

Tests of Market Efficiency

 SML can also be used for testing market efficiency.

 When markets are efficient, the scope for abnormal

returns will not be there and returns on all securities

will be commensurate with the underlying risk.
 That is, all assets are correctly priced and provide a

normal return for their level of risk and the difference

between return earned on the asset and required rate
of return on the asset should be statistically
insignificant if markets are efficient.
 To test for efficiency, we need to estimate the

required rate of return along with the realized rate of

return.
 SML comes handy in estimation of the required rate

of return.
 The ex-ante SML can be used for identifying

mispriced (under and overvalued) securities.