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Capital Market Theory. Outline. Overview of Capital Market Theory Assumptions of Capital Market Theory Development of Capital Market Theory Risk-Return Combination Risk-Return Possibilities with Leverage. From Portfolio Theory to Capital Market Theory.

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Presentation Transcript
outline
Outline
  • Overview of Capital Market Theory
  • Assumptions of Capital Market Theory
  • Development of Capital Market Theory
  • Risk-Return Combination
  • Risk-Return Possibilities with Leverage
from portfolio theory to capital market theory
From Portfolio Theory to Capital Market Theory
  • Capital market theory builds on portfolio theory and develops a model for pricing all risky assets
  • The concept of a risk-free asset is critical to the development of capital market theory
  • The expected return on a risk-free asset is entirely certain and the standard deviation is zero
  • Covariance of a risk-free asset with a risky asset is zero
slide4
Expected Return of a Portfolio that contains a risk-free asset and a risky asset

E(Rp) = w x E(rA) + (1-w) x rf

  • Standard Deviation of two asset portfolio
  • Expected return and the standard deviation of expected return for such a portfolio are linear combinations
  • A graph of possible portfolio returns and risks will be a straight line between the two assets
slide5
Risk-return possibilities with Leverage
  • How can an investor attain a higher expected return than is available at point M in the graph?
  • Borrowing and lending possibilities and capital market line
  • Risk-less asset created lending and borrowing possibilities and a set of expected return and risk that did not exist before