capital market theory and capm

8/17/2019 Capital Market Theory and CAPM

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Hailey College of Bankingand Finance

Corporate FinanceInstructor: Abdul Qadeer

[email protected]!"###$%&'('%


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Capital )arket *heory begins +here the discussion of

)arko,it- /cient Frontier ends0 it !eans Capital )arket *heory e1tends 23ortfolio *heory4 and deelops a !odel 0 the

5nal product0 CA3) allo,s us to deter!ine 6equired 6ate of6eturn0 CA3) is the )odel for pricing all risky assets.

*he )a7or Factor in the deelop!ent of C)*0 ,as 6isk8freeAsset0 an asset ,ith 9ero ariance.

Capital )arket *heory


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All inestors are )arko,it- /cient Inestors

Inestors can borro, or lend at 6isk8Free 6ate ;6F6<

=a!e 1pectations *he *i!e Hori-on is equal for All Inestors

All Assets are In5nitely >iisible

*here are no ta1es or transaction costs inoled inbuying or selling assets

?o Ination or any change in interest rates

*here is ?o )ispricing +ithin the Capital )arkets 8Assu!e the !arkets are e/cient and that no !ispricing,ithin the !arkets e1ist.

Assu!ptions of Capital )arket *heory


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*,o 3oints are i!portant:

6ela1ing so!e of these assu!ptions can i!ply!inor i!pact on the !odel and ,ould not alterits !ain i!plications or conclusions.

A theory should neer be 7udged on the basis ofits assu!ptions but0 rather0 on ho, ,ell ite1plains and help us predict behaior in the real,orld.

nrealistic Assu!ptions andsefulness of *heory


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*,o 3oints are i!portant:

6ela1ing so!e of these assu!ptions can i!ply!inor i!pact on the !odel and ,ould not alterits !ain i!plications or conclusions.

A theory should neer be 7udged on the basis ofits assu!ptions but0 rather0 on ho, ,ell ite1plains and help us predict behaior in the real,orld.

nrealistic Assu!ptions andsefulness of *heory


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*he CA3) is often critici-ed as being unrealistic because of the

assu!ptions on ,hich it is based0 so it is i!portant to be

a,are of these assu!ptions and the reasons ,hy they are

critici-ed. *he assu!ptions are as follo,s. Investors hold diversifed portolios

*his assu!ption !eans that inestors ,ill only require a return

for the syste!atic risk of their portfolios0 since unsyste!atic

risk has been re!oed and can be ignored.

Single-period transaction horizonA standardi-ed holding period is assu!ed by the CA3) in orderto !ake co!parable the returns on dierent securities. Areturn oer si1 !onths0 for e1a!ple0 cannot be co!pared to a

return oer ( !onths. A holding period of one year is usually

used.

Criticism on CAPM


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Investors can borrow and lend at the risk-ree rate o return

*his is an assu!ption !ade by portfolio theory0 fro! ,hich the CA3),as deeloped0 and proides a !ini!u! leel of return required by

inestors. *he risk8free rate of return corresponds to the intersectionof the security !arket line ;=)D< and the y8a1is ;see Figure


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+hile the assu!ptions !ade by the CA3) allo, it to focus on the

relationship bet,een return and syste!atic risk0 the ideali-ed ,orldcreated by the assu!ptions is not the sa!e as the real ,orld in ,hichinest!ent decisions are !ade by co!panies and indiiduals.

For e1a!ple0 real8,orld capital !arkets are clearly not perfect. enthough it can be argued that ,ell8deeloped stock !arkets do0 inpractice0 e1hibit a high degree of e/ciency0 there is scope for stock

!arket securities to be priced incorrectly and0 as a result0 for their

returns not to plot on to the =)D.

*he assu!ption of a single8period transaction hori-on appearsreasonable fro! a real8,orld perspectie0 because een though !any

inestors hold securities for !uch longer than one year0 returns onsecurities are usually quoted on an annual basis.

Criticis! on CA3)


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*he assu!ption that inestors hold diersi5ed portfolios !eans that all

inestors ,ant to hold a portfolio that reects the stock !arket as a,hole. Although it is not possible to o,n the !arket portfolio itself0 it is

quite easy and ine1pensie for inestors to diersify a,ay speci5c orunsyste!atic risk and to construct portfolios that trackG the stock!arket. Assu!ing that inestors are concerned only ,ith receiing5nancial co!pensation for syste!atic risk see!s therefore to be quitereasonable.

A !ore serious proble! is that0 in reality0 it is not possible for inestors

to borro, at the risk8free rate ;for ,hich the yield on short8datedoern!ent debt is taken as a pro1y


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erall0 it see!s reasonable to conclude that

,hile the assu!ptions of the CAPM

represent an idealized rather than real-world view0 there is a strong possibility0 inreality0 of a linear relationship e1istingbet,een required return and syste!atic risk.

capital market theory and capm

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