Portfolio Management  Capital Market Theory
The capital market theory builds upon the Markowitz portfolio model. The main assumptions of the capital market theory are as follows:
 All Investors are Efficient Investors  Investors follow Markowitz idea of the efficient frontier and choose to invest in portfolios along the frontier.
 Investors Borrow/Lend Money at the RiskFree Rate  This rate remains static for any amount of money.
 The Time Horizon is equal for All Investors  When choosing investments, investors have equal time horizons for the choseninvestments.
 All Assets are Infinitely Divisible  This indicates that fractional shares can be purchased and the stocks can be infinitely divisible.
 No Taxes and Transaction Costs assume that investors' results are not affected by taxes and transaction costs.
 All Investors Have the Same Probability for Outcomes When determining the expected return, assume that all investors have the same probability for outcomes.
 No Inflation Exists  Returns are not affected by the inflation rate in a capital market as none exists in capital market theory.
 There is No Mispricing Within the Capital Markets  Assume the markets are efficient and that no mispricings within the markets exist.
What happens when a riskfree asset is added to a portfolio of risky assets?
To begin, the riskfree asset has a standard deviation/variance equal to zero for its given level of return, hence the "riskfree" label.
 Expected Return  When the RiskFree Asset is Added
Given its lower level of return and its lower level of risk, adding the riskfree asset to a portfolio acts to reduce the overall return of the portfolio.
Example: RiskFree Asset and Expected Return
Assume an investor's portfolio consists entirely of risky assets with an expected return of 16% and a standard deviation of 0.10. The investor would like to reduce the level of risk in the portfolio and decides to transfer 10% of his existing portfolio into the riskfree rate with an expected return of 4%. What is the expected return of the new portfolio and how was the portfolio's expected return affected given the addition of the riskfree asset?
Answer:
The expected return of the new portfolio is: (0.9)(16%) + (0.1)(4%) = 14.4%
With the addition of the riskfree asset, the expected value of the investor's portfolio was decreased to 14.4% from 16%.
 Standard Deviation  When the RiskFree Asset is Added
As we have seen, the addition of the riskfree asset to the portfolio of risky assets reduces an investor's expected return. Given there is no risk with a riskfree asset, the standard deviation of a portfolio is altered when a riskfree asset is added.
Example: Riskfree Asset and Standard Deviation
Assume an investor's portfolio consists entirely of risky assets with an expected return of 16% and a standard deviation of 0.10. The investor would like to reduce the level of risk in the portfolio and decides to transfer 10% of his existing portfolio into the riskfree rate with an expected return of 4%. What is the standard deviation of the new portfolio and how was the portfolio's standard deviation affected given the addition of the riskfree asset?
Answer:
The standard deviation equation for a portfolio of two assets is rather long, however, given the standard deviation of the riskfree asset is zero, the equation is simplified quite nicely. The standard deviation of the twoasset portfolio with a risky asset is the weight of the risky assets in the portfolio multiplied by the standard deviation of the portfolio.
Standard deviation of the portfolio is: (0.9)(0.1) = 0.09
Similar to the affect the riskfree asset had on the expected return, the riskfree asset also has the affect of reducing standard deviation, risk, in the portfolio.
Related Articles

Career Education & Resources
How Hard are the CFA Exams?
Learn about the difficulty of the CFA exams with a description of the tests, some statistics on pass rates and suggestions that can help you pass the exams. 
Professionals
What it Takes to be a Financial Analyst
A financial analyst researches companies and economic conditions to make business, sector and industry recommendations. 
Career Education & Resources
Financial Analyst: Career Path & Qualifications
Read about what it takes to become a financial analyst in a corporation or securities firm, and learn how far you can rise in the profession. 
Career Education & Resources
Financial Planner: Career Path & Qualifications
Learn what education and certifications you need to become a financial planner, as well as the future prospects and earnings potential for financial planners. 
Career Education & Resources
Where to Find NonProfit Finance Jobs
The nonprofit sector offers a stable selection of jobs for those who seek other types of fulfillment from their jobs than just purely financial. 
Career Education & Resources
Portfolio Manager: Career Path & Qualifications
Learn about the basic requirements for getting hired as a portfolio manager, and discover how most professionals in the field rise into the position. 
Your Practice
4 Professional Associations Advisors Should Join
These four professional organizations are among the most respected and well known in the industry. 
Professionals
Equity Research: Career Path and Qualifications
Find out what equity research analysts do on a daytoday basis, and learn more about the typical career progression for these securities professionals. 
Professionals
What's on the CFA Level II Exam?
The Chartered Financial Analyst Level II exam is the second of three tests that CFA candidates must pass. 
Professionals
Financial Data Analyst: Career Path & Qualifications
Learn more about the career options available to financial data analysts, and determine whether the profession is a good match for you.
RELATED TERMS

Personal Financial Advisor
Professionals who help individuals manage their finances by providing ... 
CFA Institute
Formerly known as the Association for Investment Management and ... 
Chartered Financial Analyst  CFA
A professional designation given by the CFA Institute (formerly ... 
Security Analyst
A financial professional who studies various industries and companies, ...
RELATED FAQS

What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...
The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >> 
How do I become a Chartered Financial Analyst (CFA)?
According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >> 
What types of positions might a Chartered Financial Analyst (CFA) hold?
The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >> 
Who benefits the most from prepaid expenses?
Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >> 
If I am looking to get an Investment Banking job. What education do employers prefer? ...
If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >> 
Can I still pass the CFA Level I if I do poorly in the ethics section?
You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>