PORTFOLIO THEORY AND CAPM

Relevance Of Portfolio Theory And CAPM To An Investor Or Fund Manager In The Equity Markets

Table of Contents

INTRODUCTION3

PORTFOLIO THEORY3

CAPITAL ASSET PRICING MODEL - CAPM3

HELPS IN REDUCING RISK4

ADVANTAGES AND DISADVANTAGES6

CALCULATION EXAMPLES8

CONCLUSION9

REFERENCES11

Relevance Of Portfolio Theory And CAPM To An Investor Or Fund Manager In The Equity Markets

Introduction

Modern portfolio theory has one, and actually only one, cantered theme: “In assembling their portfolios investors need to gaze at the anticipated come back of each investment in relative to the influence that it has on the risk of the general portfolio” (Bodie et al 2008:12-20). The functional note of portfolio theory is that measuring an investment is best appreciated as an workout in balancing its anticipated come back against its assistance to portfolio risk- In an optimal portfolio this ratio between anticipated come back and the marginal assistance to portfolio risk of the next bash invested should be the identical for all assets in the portfolio (Basu 2007:129-56).

Portfolio Theory

The theory that holds that assets should be chosen on the basis of how they interact with one another rather than how they perform in isolation (Friend and Blume 2008:52). According to this theory, an optimal combination would secure for the investor the highest possible return for a given level of risk, or the least possible risk for a given level of return. Also called modern portfolio theory. (Bodie et al 2008:12-20)

Capital Asset Pricing Model - CAPM

A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time (Stambaugh 2002:10). The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf). (Bodie et al 2008:12-20)

Helps in reducing Risk

CAPM is just a model with simple premises, but it is still the most important model to describe financial markets. The theory behind the CAPM and all other modern finance theories are based on the portfolio theory, developed in the early 1950`s by Harry Markowitz. His statement was that an investor can reduce the standard deviation of portfolio returns by choosing stocks that do not move exactly together (that are correlated differently). Furthermore, expected returns and standard deviation are the only two variables that need to be considered in an investment decision. The intuition behind the CAPM is the insurance motive of risk averse investors. The main statement of the CAPM is that one can reduce risk nicely diversifying one's portfolio. (Jensen 1968:10)

The assumed point of departure is that there is a competitive market ...