Finance

  The Equilibrium Return-Risk Tradeoff: Given the previous analysis, we can now derive some predictions concerning equilibrium expected returns and risk. On an overall basis, we need an equilibrium model that encompasses two important relationships.  The capital market line specifies the equilibrium relationship between expected return and risk for efficient portfolios.  The security market line specifies the equilibrium relationship between expected return and systematic risk. It applies to individual securities as well as portfolios. THE CAPITAL MARKET LINE: The capital market line (CML) represents portfolios that optimally combine risk and return.  Capital asset pricing model  (CAPM), depicts the trade-off between risk and return for efficient portfolios. It is a theoretical concept that represents all the portfolios that optimally combine the  risk-free rate of return  and the market portfolio of risky assets. Under CAPM, all investors will choose ...

  RISK-FREE BORROWING AND LENDING: Assume that the efficient frontier, as shown by the arc AB in Figure 9-1, has been derived by an investor. The arc AB delineates the efficient set of portfolios of risky assets as explained in (For simplicity, assume these are portfolios of common stocks.) We now introduce a risk-free asset with return RF and σ = 0 . As shown in Figure 9-1, the return on the risk-free asset (RF) will plot on the vertical axis because the risk is zero. Investors can combine this riskless asset with the efficient set of portfolios on the efficient frontier. By drawing a line between RF and various risky portfolios on the efficient frontier, we can examine combinations of risk-return possibilities that did not exist previously. Lending Possibilities:  In Figure 9-1 a new line could be drawn between RF and the Markowitz efficient frontier above point X, for example, connecting RF to point V. Each successively higher line will dominate the preceding set of po...

 INTRODUCTION OF THE RISK-FREE ASSET: The first assumption of capital market theory listed above is that investors can borrow and lend at the risk-free rate. Although the introduction of a risk-free asset appears to be a simple step to take in the evolution of portfolio and capital market theory, it is a very significant step. In fact, it is the introduction of a risk-free asset that allows us to develop capital market theory from portfolio theory.  With the introduction of a risk-free asset, investors can now invest part of their wealth in this asset and the remainder in any of the risky portfolios in the Markowitz efficient set. This allows Markowitz portfolio theory to be extended in such a way that the efficient frontier is completely changed, which in turn leads to a general theory for pricing assets under uncertainty.  Defining a Risk-Free Asset: An asset which an indubitable return is a risk-free asset. This type of asset has a  definite future return, regardl...

 The Equation for the CML: We now know the intercept and slope of the CML. Since the CML is the tradeoff between expected return and risk for efficient portfolios, and risk is being measured by the standard deviation, the equation for the CML is shown as Equation 9-1: where:  E (Rp) = the expected return on any efficient portfolio on the CML   RF = the rate of return on the risk-free asset   E (RM) = the expected return on the market portfolio M   σM = the standard deviation of the returns on the market portfolio   σp = the standard deviation of the efficient portfolio being considered  In words, the expected return for any portfolio on the CML is equal to the risk-free rate plus a risk premium. The risk premium is the product of the market price of risk and the amount of risk for the portfolio under consideration. Important Points About the CML:   The following points should be noted about the CML:  1. Only efficient port...

 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, whic...