The work on valuation models for risky assets continues with the capital market theory and the concurrent development of the capital asset pricing model (CAPM).
The capital market theory builds on the Markowitz portfolio theory, expanding further the concepts of risky assets and the efficient frontier. The starting assumption is that in order to maximize his or her portfolio returns, the Markowitz efficient investor will choose a portfolio that will offer the maximum return for the minimum risk. The capital market theory's final product, the capital asset pricing model (CAPM), allows investors to estimate the required rate of return for any risky asset and use it in the investment decision process.
Capital Market Theory Assumptions
The development of the capital market theory and CAPM is generally attributed to the Nobel Prize winner William Sharpe, as well as to two other economists, John Virgil Lintner and Jan Mossin, who arrived to similar asset pricing models independently. Since the capital market theory continues essentially where the Markowitz portfolio theory left off, we are operating within the similar set of assumptions, adding also a few new ones.
Firstly, all investors are assumed to be Markowitz efficient investors, targeting their respective points on the efficient frontier that depend on their individual risk versus return situations.
It is also assumed that efficient investors will always have access to borrowed funds, or, at the very least, have the ability to lend funds at the risk-free rate of return. In case of this particular assumption, it is clear that lending funds at the risk-free rate should not represent the problem.
However, there might be issues with borrowing funds at the risk-free rate. It is certainly possible to do so, but borrowing at the risk-free rate also assumes no profit from the costs of borrowing for the lender. Obviously, there will have to be other ways to compensate the lender, which may result in limited availability of borrowed funds at the risk-free rate.
The capital market theory also assumes that all investors have almost identical expectations of future rates of return, that they operate within similar investment periods (one month, six months, one year), and that there are no tax or transaction costs involved when computing the required rates of return. Note that with each of these assumptions, there is considerable room to relax them.
Finally, the capital market theory assumes that capital markets are in equilibrium, which means that all the supply has met all the demand and that all assets on the capital market line have been properly priced on their risk-adjusted basis. This also means that there is either no inflation or that effects of inflation have been fully expected.
Risk-Free Asset
The concept of a risk-free asset is essential to asset pricing models. Note that the risk-free asset offers returns that are certain and fully expected, and which are based on the expected growth rate of the overall economy in the long-run, adjusted for any short-term liquidity risks. Both the efficient frontier and capital market lines start at the risk-free rate point on the x-axis. From that point, both variables increase in a linear fashion.
The Market Portfolio
The market portfolio lies on the capital market line at its highest possibility tangent. It is assumed to include all risky assets in proportion to their relative market values and it is the target portfolio for every investor. To achieve the market portfolio, investors will either lend funds at the risk-free rate and use the proceeds to buy risky assets contained in the market portfolio, or borrow funds to do the same.
The market portfolio is assumed to contain all risky assets, not just stocks or bonds, but also derivatives, real estate, antiques, numismatic collections, pieces of art, etc. This is also perhaps the market portfolio’s worst limitation, since it is nearly impossible to construct such a diverse portfolio.
Since the market portfolio is assumed to contain all risky assets, it is also assumed to be completely diversified. This means that any and all risk unique to each particular asset class contained within the market portfolio has been completely diversified away, leaving as a residual only the systematic risk.
If you recall from the CAPM article, the diversifiable portion of risk is also called unsystematic risk, while the systematic risk was defined as the risk level that cannot be diversified and which has been caused by macroeconomic variables. In addition, as macroeconomic variables change over time, so does the level of systematic risk in the market portfolio. Examples of such macroeconomic variables include increases or decreases in money supply, interest rates, corporate earnings, economic output, levels of employment, etc.
What Is the Significance of the Market Portfolio?
Simply, all investors want to be invested in the market portfolio at some tangent point. However, while uniformity of investment decisions may be implied within this definition, it is decidedly not so. Individual investors’ financing and investment decisions will be distinctly separate, since some investors might lend money first at the risk-free rate and then use interest income to purchase risky assets, while others might borrow funds at the same rate, and use those funds to invest in risky assets. In either case, the key determining factor will be investors’ risk tolerance levels relative to their required rates of return.
(Source: Investment Analysis and Portfolio Management, Eighth Edition, by Frank K. Reilly and Keith C. Brown, 2005)
