Capital Market Theory

FINANCE IN A CANADIAN
SETTING
Sixth Canadian Edition
Lusztig, Cleary, Schwab
CHAPTER EIGHT
CAPITAL MARKET THEORY

Learning Objectives
1. Explain the role of risk-free assets in an

efficient portfolio.
2. Define the capital market line (CML), and
explain what its slope indicates.
3. Compare and contrast systematic and non-
systematic risk, and discuss the role of each
in establishing the security market line
(SML).
Learning Objectives
4. Define beta measure, and explain why it is

more stable for large portfolios than for
small ones than for individual stocks.
5. Identify some of the weaknesses in the
capital asset pricing model (CAPM), and
discuss alternative theories.
Building Efficient Portfolios
 Use approach based on portfolio theory developed
by Harry Markowitz
 Portfolio theory is a normative meaning that tells
investors how they should act to diversify optimally,
which is based on the following assumptions:
1. A single investment period
2. Liquidity of positions
3. Investors preference based only on
a portfolio’s expected return and risk
4. Homogenous expectations among investors
regarding expected return and risk
The Efficient Set of Portfolios
• According to Markowitz’s approach, investors

should evaluate portfolios based on their
return and risk as measured by the standard
deviation
 Efficient portfolio – a portfolio that has the
smallest portfolio risk for a given level of
expected return or the largest expected
return for a given level of risk
 The construction of efficient portfolios of

financial assets requires identification of
optimal risk-expected return combinations
attainable from the set of risky assets
available
 Efficient portfolios can be identified by
specifying an expected portfolio return and
minimizing the portfolio risk at this level of
return
The Attainable Set and the Efficient Set of
Portfolios
 Risk averse investors should only be interested in

portfolios with the lowest possible risk for any
given level of return
 Efficient set (frontier) – is the segment of the
minimum variance frontier above the global
minimum variance portfolio that offers the best
risk-expected return combinations available to
investors
 Portfolios along the efficient frontier are equally
“good”
Borrowing and Lending
Possibilities
 Investors have the option of buying
risk-free assets
 Investors can invest part of their wealth

in risk-free asset and the rest in risky
assets resulting in a new efficient
frontier
Borrowing and Lending
Possibilities
The Markowitz Efficient Frontier and the Possibilities
Resulting from Introducing a Risk-Free Asset
Risk-Free Lending
 The expected return on a combined portfolio
of risk-free and risky assets would be:
E ( R p )  wrf  (1  wrf ) E ( Rx )
 Since the of risk-free assets is equal to 0
than the  of the portfolio would be:
 p  (1  wRF ) x
Risk-Free Lending
 Through a combination of risk-free

investing and investing in a portfolio of
risky assets, investors can improve the
opportunity set available from the
efficient frontier
Borrowing Possibilities
 Investors are no longer restricted to their
initial wealth when investing in risky assets.
 Investors can:
 Buy stock on margin
 Borrow at the risk-free rate
 Borrowing additional funds for investment
purposes allows investors to seek higher
expected returns while assuming more risk
The Efficient Frontier when Lending and
Borrowing Possibilities Are Allowed
 The proportion to be invested in the

alternatives are stated as a percentage
of an investor’s total investable funds
with the different combinations adding
up to 1.0
wRF  (1  wRF )  1.0  100%

The Capital Asset Pricing
Model (CAPM)
 Capital market theory is concerned with
equilibrium security prices and returns and
how they are related to the risk-expected
return trade-off that investors face
 It measures the relative risk of an
individual security and the relationship
between risk and the returns expected
from investing
Capital Market Line (CML)
 Depicts the equilibrium conditions that

prevail in the market for efficient
portfolios consisting of the optimal
portfolio of risk-free and risky assets
 All combinations of assets are bound by
the CML and at equilibrium all investors
end up with efficient portfolios
 Slope of the CML is the market price of risk
for efficient portfolios
 Slope of the CML = E ( RM )  RF

M
 The CML is always upward sloping because
the price of risk is always positive
The CML and the Components of Its Slope

The Security Market Line
(SML)
 The SML is the key contribution of the CAPM
to asset pricing theory
 The SML equation is:
E ( Ri )  RF   E ( RM )  RF   i
 The SML represents the trade-off between
systematic (as measured by beta) and
expected returns for all assets
The Security Market Line
(SML)
 It is depicted as the line from RF-Z in
Figure 8.6
Beta
 Beta – the measure of the systematic risk of a
security that cannot be avoided through
diversification
 Beta measures a security’s volatility in price
relative to a benchmark
• Beta – risk-free asset = 0
– market portfolio = 1.0
• Stocks -  betas are higher risk securities
 betas are lower risk securities
Portfolio Betas
 Are weighted averages of the betas for

individual securities in the portfolio
 The equation is:
 p  w1 1  w2  2  ...wn  n
Over- and Undervalued
Securities
• Securities plotted above the SML are
undervalued because they offer more
expected return given its beta
• Securities plotted below the SML are
overvalued because they offer less
expected return given its beta
Summary
1. An efficient portfolio has the highest

expected return for a given level of risk or
the lowest level of risk for a given level of
expected return.
2. Capital market theory, based on the concept
of efficient diversification, describes the
pricing of capital assets in the market place.
The new efficient frontier is called the capital
market line (CML), and its slope indicates the
equilibrium price of risk in the market.
Summary
3. Based on the separation of risk into its

systematic and non-systematic components,
the security market line (SML) can be
constructed for individual securities (and
portfolios).
4. Beta is a relative measure of risk, which
indicates the volatility of a stock relative to a
market index. While all betas change through
time, betas for large portfolios are much
more stable than those for individuals stocks

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FINANCE IN A CANADIAN

CAPITAL MARKET THEORY

1. Explain the role of risk-free assets in an

4. Define beta measure, and explain why it is

• According to Markowitz’s approach, investors

 The construction of efficient portfolios of

 Risk averse investors should only be interested in

 Investors can invest part of their wealth

 Through a combination of risk-free

 The proportion to be invested in the

wRF  (1  wRF )  1.0  100%

 Depicts the equilibrium conditions that

 Slope of the CML = E ( RM )  RF

The CML and the Components of Its Slope

 Are weighted averages of the betas for

1. An efficient portfolio has the highest

3. Based on the separation of risk into its

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