Chapter 08 - Portfolio Theory and the Capital Asset Pricing Model
Chapter 8 Portfolio Theory and the Capital Asset Pricing Model
OVERVIEW
This is a very important chapter, as it deals with portfolio theory and the capital asset pricing model
(CAPM). This is a difficult chapter, and students find it hard to understand the concepts fully. The
concepts of efficient portfolios and the risk-free asset are explained clearly. The chapter concentrates on
the Markowitz portfolio selection model and CAPM and builds on the previous chapter. Other theories
like arbitrage pricing theory (APT) and the three-factor model are discussed.
LEARNING OBJECTIVES
To understand the portfolio theory and the related concepts of efficient portfolios, the market
portfolio, and the risk-free asset.
To understand CAPM, the security market line (SML), and its implications for risk-return trade-
offs.
To understand other theories like the arbitrage pricing theory and the three-factor model.
CHAPTER OUTLINE
Harry Markowitz and the birth of portfolio theory
This section starts by taking a close look at daily returns of stock and compares them with the normal
distribution. The risk and return of a portfolio is reviewed. The idea of an efficient portfolio is introduced.
Finally, it is shown that when risk-free borrowing or lending is allowed, the investor can easily identify
the best portfolio of risky assets.
The relationship between risk and return
This section describes the security market line and shows how it can be used to estimate the required rate
of return on a common stock. The capital asset pricing model and its usefulness are described in this
section.
Validity and role of the capital asset pricing model
This section briefly reviews the assumptions underlying the capital asset pricing model and also provides
the empirical evidence supporting it. An important point is that while the capital asset pricing model is
not perfect, it does seem to capture important elements of risk. It is worth emphasizing the role of the
market portfolio in the capital asset pricing model. For any efficient portfolio, the expected risk premium
on each stock (r – rf) must be proportional to its beta measured relative to that efficient portfolio. If the
market portfolio is efficient, then (r – rf) will be proportional to beta measured relative to the market
portfolio (i.e., the capital asset pricing model will hold).
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McGraw-Hill Education.
Chapter 08 - Portfolio Theory and the Capital Asset Pricing Model
The capital asset pricing model is equivalent to the statement that the market portfolio is mean-variance
efficient. This makes the model difficult to test conclusively. The market portfolio should, in principle,
include all assets; the available market indexes clearly fall short of that ideal. Assumptions behind the
capital asset pricing model are:
Investors maximize the expected utility of terminal wealth at the end of one period.
Investors choose between portfolios on the basis of the mean and variance of return. This implies
that investors have quadratic utility functions or (more realistically) that returns are normally
distributed.
Investors can borrow or lend at an exogenously determined risk-free rate of interest.
There are no restrictions on short selling.
Investors have homogeneous probability beliefs.
The market is perfect. Thus, all assets are marketable, there are no transaction costs or taxes, and
all investors are price takers.
Some alternative theories
Alternative models of risk and return are explained: the arbitrage pricing theory (APT) and the three-
factor model. A comparative analysis of the CAPM and APT is provided. A comparison of the three-
factor model and the CAPM is provided. This section also points out the difficulties inherent in testing
and using these models in practice.
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Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
