Market Portfolio Theory and Capital Asset Pricing Model

CORPORATE FINANCE
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Section A
Market Portfolio Theory (MPT) seeks to combine risk and returns as two key attributes
associated with any particular investment. The basic premise of this theory is that risk and
return ought to be not viewed in isolation as they are related with each other. It assumes that
all investors are rational and hence risk averse (Arnold, 2015). Therefore, any investor would
like to invest in an asset which tends to provide high returns while keeping the risk low.
However, this rarely happens as higher returns are provided as an incentive to the investor so
as to invest in the risky asset and thereby assume the incremental risk (Berk et. al., 2013).
According to MPT, the objective of an investor should not be to minimise risk in isolation or
maximise return in isolation but instead maximise the return per unit risk assumed. For this,
MPT suggests that efficient portfolios should be formed based on the underlying risk appetite
of the concerned investor. It is possible for the investor to find a portfolio which would
maximise the returns for a given value of risk that the investor has appetite for. As a result,
the best investment is one which is denoted by efficient frontier and refers to the precise
weightage of the assets in the portfolio which would result in highlighted return for the
investor (Damodaran, 2015).
Also, MPT highlights the concept of portfolio formation and hints at the reduction of risk
through diversification. In this regards, it offers the formula for computation of associated
risk and returns for a given portfolio. In order to obtain the efficient frontier, various
combinations of the two given assets are plotted on a graph with risk of portfolio denoted on
the X axis and returns of portfolio being denoted on the Y axis, Considering the scatter of
these two variables, the optimum portfolio may be identified. As a result, it may be stated that
MPT has played a crucial role with regards to laying the foundation for modern day portfolio
formation (Petty et. al., 2015).
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Section B
The techniques of portfolio management can be reliably applied only when there is accurate
estimation of the systematic risk that tends to be linked with a given security. In this regards ,
a key role is played by the Capital Asset Pricing Model (CAPM) which essentially derives
from the modern portfolio theory and was suggested in the 1960’s. The basic premise of the
CAPM model is that with regards to the returns that investors would expect on their
investment, there would be two components. One would be the opportunity cost as the money
invested in a given security could have been invested in the risk free asset and returns could
have been earned (Christensen et. al., 2013). As a result, the CAPM approach first
compensates the investor by providing the risk free rate. The second component provides risk
adjusted returns based on the underlying risk of the underlying investment. The yardstick in
this process is the market index which tends to have a beta of 1. The beta of the underlying
investment would act as a measure of risk which would highlight the risk of the stock in
comparison to the market. Hence, in line with the modern portfolio theory, investors are
compensated for assuming higher risk (Brealey, Myers and Allen, 2014).
The CAPM model can be captured using the following linear equation (Kane & Marcus,
2013).
The various key elements in the above equation are defined below.
E(R) – Expected returns on the given stock
Rf – Rare on the risk free asset
Β – Beta or measure of systematic risk for the given stock
Rm – Highlights the expected market index returns based on empirical performance
The linear equation indicated above can be captured graphically and tends to known as the
Security Market Line as highlighted below (Damodaran, 2015).
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It is evident from the above diagram that by focusing on the underlying relationship between
returns and risk, the CAPM approach can help the managements in evaluation of associated
risk with the various investment. This can then be compared to the actual risk which can form
a basis for taking investment calls (Brigham and Houston, 2014).
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