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:

  1. All Investors are Efficient Investors - Investors follow Markowitz idea of the efficient frontier and choose to invest in portfolios along the frontier.
  2. Investors Borrow/Lend Money at the Risk-Free Rate - This rate remains static for any amount of money.
  3. The Time Horizon is equal for All Investors - When choosing investments, investors have equal time horizons for the choseninvestments.
  4. All Assets are Infinitely Divisible - This indicates that fractional shares can be purchased and the stocks can be infinitely divisible.
  5. No Taxes and Transaction Costs -assume that investors' results are not affected by taxes and transaction costs.
  6. All Investors Have the Same Probability for Outcomes -When determining the expected return, assume that all investors have the same probability for outcomes.
  7. No Inflation Exists - Returns are not affected by the inflation rate in a capital market as none exists in capital market theory.
  8. 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 risk-free asset is added to a portfolio of risky assets?
To begin, the risk-free asset has a standard deviation/variance equal to zero for its given level of return, hence the "risk-free" label.

  • Expected Return - When the Risk-Free Asset is Added
    Given its lower level of return and its lower level of risk, adding the risk-free asset to a portfolio acts to reduce the overall return of the portfolio.

    Example: Risk-Free 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 risk-free 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 risk-free asset?

    Answer:
    The expected return of the new portfolio is: (0.9)(16%) + (0.1)(4%) = 14.4%

    With the addition of the risk-free asset, the expected value of the investor's portfolio was decreased to 14.4% from 16%.
  • Standard Deviation - When the Risk-Free Asset is Added
    As we have seen, the addition of the risk-free asset to the portfolio of risky assets reduces an investor's expected return. Given there is no risk with a risk-free asset, the standard deviation of a portfolio is altered when a risk-free asset is added.

    Example: Risk-free 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 risk-free 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 risk-free asset?

    Answer:
    The standard deviation equation for a portfolio of two assets is rather long, however, given the standard deviation of the risk-free asset is zero, the equation is simplified quite nicely. The standard deviation of the two-asset 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 risk-free asset had on the expected return, the risk-free asset also has the affect of reducing standard deviation, risk, in the portfolio.
The Capital Market Line
Related Articles
  1. Professionals

    Chinese Slowdown Affects Iron Ore Market

    The Chinese economy's ongoing slowdown is having a major impact on iron ore demand.
  2. Personal Finance

    Invest in Costco? First Understand Its Balance Sheet

    A strong balance sheet sets a company apart and boosts investor confidence. How healthy is Costco based on an analysis of its balance sheets from the last two years?
  3. Investing Basics

    Brokers and RIAs: One and the Same?

    Brokers and registered investment advisors have some key differences. Here's what you need to know.
  4. Professionals

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  5. Professionals

    How To Make Money Using Tobin's Q Ratio

    Although it seems simple, Tobin's Q Ratio is more complex than it appears. We explore some of its main strengths and weaknesses.
  6. Taxes

    3 Secrets You Didn't Know About Estate Planning

    Every advisor and saver needs to know these three estate planning secrets.
  7. Professionals

    Cash Flow Is King: How to Keep it Running

    Why is cash flow so important, and what steps can a business take to improve it?
  8. Entrepreneurship

    10 Ways to Nurse Cash Flow in Healthcare

    Running a business in healthcare? You might want to rethink cash flow management practices.
  9. Professionals

    How to Help Clients with Cash Flow Issues

    Sometimes your spending gets out of hand or income has a hiccup. Here's how financial advisors can help clients who have cash flow issues.
  10. Professionals

    How to Improve Your Cash Flow in Manufacturing

    Here are 10 ways to to improve a manufacturer's cash flow.
RELATED TERMS
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
RELATED FAQS
  1. 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 >>
  2. 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 >>
  3. 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 >>
  4. 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 >>
  5. 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 >>
  6. 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 >>
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!