Investors are price takers whose individual buy and sell transactions do not affect the price.CAPM explains that the market equilibrium is attained when all investors hold portfolios whose constituents are a combination of riskless assets and the market portfolio. The Capital Asset Pricing Model, derived by Sharpe, Lintner, and Mossin, stipulates assumptions regarding the market and how investors behave to enable the creation of an equilibrium model of prices in the whole market. Inefficient portfolios imply that the investor achieves the lowest level of return given any level of risk. The dotted line represents the most inefficient portfolios in this case, portfolio L. Portfolio P is also an efficient portfolio but representing a lower level of risk than portfolio M.įrom the efficient frontier, it is easy to see that the expected return is increased by increasing the portfolio’s risk level and vice versa. The market portfolio assumes that the market attains the equilibrium and appropriately includes all the risky assets in the economy weighted by their respective market values. Portfolio M is referred to as the market portfolio. On the other hand, portfolio K is termed as suboptimal since there are other portfolios (located on the vertical distance between the portfolio K and the efficient frontiers) that can offer better returns for the same level of risk, namely portfolio M. Portfolio P gives the best return for the same level of risk. Now, consider the following efficient frontier. Each point on the curve represents the maximum level of portfolio return for a given level of risk. The Markowitz Efficient Frontier (or only efficient frontier) is a curved solid curve with a plot of the optimal returns for each level of risk.

Diversification enables the maximization of the level of returns at any provided level of risk. Thus, investors must be compensated for accepting the risk in each asset. Portfolio diversification is one method of decreasing the risk exposure to each asset. The assets’ performance is not evaluated independently but rather with the performance of other assets. Markowitz suggested that the size of investment made by an institution should be based on the contribution of the assets to the entire portfolio’s return (in terms of mean and return). This allows the characteristics of the returns to be stated in terms of the mean and the variance. II. The returns from the portfolios are normally distributed.

There is perfect competition in the market.

All market participants can access available information without any cost.

There are no transaction costs and taxes.Assumptions of the Modern Portfolio Theory Modern portfolio theory is attributed to Harry Markowitz, who postulated that a rational investor should evaluate the potential portfolio allocations based on means and variances of the expected return distributions. Calculate, compare, and interpret the following performance measures: the Sharpe performance index, the Treynor performance index, the Jensen performance index, the tracking error, information ratio, and the Sortino ratio.Įxam tip: Be sure to understand the calculations behind the CAPM because there is a strong likelihood you will be getting mathematical questions on this in your FRM part 1 exam.Interpret beta and calculate the beta of a single asset or portfolio.Apply the CAPM in calculating the expected return on an asset.Interpret and compare the capital market line and the security market line.Describe the assumptions underlying the CAPM.Understand the derivation and components of the CAPM.Explain modern portfolio theory and interpret the Markowitz efficient frontier.After completing this reading, you should be able to:

Capital asset pricing model