Capital Market Theory

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 Capital Market Theory:

Capital market theory is a positive theory in that it hypothesizes how investors do behave rather than how investors should behave, as in the case of modern portfolio theory (MPT). 

It is reasonable to view capital market theory as an extension of portfolio theory, but it is important to understand that MPT is not based on the validity, or lack thereof, of capital market theory. 

The specific equilibrium model of interest to many investors is known as the capital asset pricing model, typically referred to as the CAPM. It allows us to assess the relevant risk of an individual security as well as to assess the relationship between risk and the returns expected from investing. 

The CAPM is attractive as an equilibrium model because of its simplicity and its implications. As a result of serious challenges to the model over time, however, alternatives have been developed. The primary alternative to the CAPM is arbitrage pricing theory, or APT, which allows for multiple sources of risk.

CAPITAL MARKET THEORY ASSUMPTIONS:

Capital market theory involves a set of predictions concerning equilibrium expected returns on risky assets. It typically is derived by making some simplifying assumptions in order to facilitate the analysis and help us to more easily understand the arguments without fundamentally changing the predictions of asset pricing theory. 

              Capital market theory builds on Markowitz portfolio theory. Each investor is assumed to diversify his or her portfolio according to the Markowitz model, choosing a location on the efficient frontier that matches his or her return-risk references. Because of the complexity of the real world, additional assumptions are made to make individuals more alike: 

1. All investors can borrow or lend money at the risk-free rate of return.

2. All investors have identical probability distributions for future rates of return; they have homogeneous expectations (Homogeneous Expectations Investors have the same expectations regarding the expected return and risk of securities) with respect to the three inputs of the portfolio model expected returns, the variance of returns, and the correlation matrix. Therefore, given a set of security prices and a risk-free rate, all investors use the same information to generate an efficient frontier. 

3. All investors have the same one-period time horizon. 

4. There are no transaction costs. 

5. There are no personal income taxes—investors are indifferent between capital gains and dividends. 

6. There is no inflation

7. There are many investors, and no single investor can affect the price of a stock through his or her buying and selling decisions. Investors are price-takers and act as if prices are unaffected by their own trades. 

8. Capital markets are in equilibrium.


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