6. MARKET PORTFOLIO
Market portfolio represents
such a portfolio, in which all
the securities traded in the
market find exactly the same
proportion in which these
represent themselves in the
overall market capitalisation.
7. CAPITAL ASSET PRICING MODEL
(CAPM)
Capital asset pricing model was developed by
William Sharpe to address two important
aspects related to risk and return. An investor
will be able to select optimal portfolio with
the help of analysing the relationship
between risk and return.
Relationship between risk and return for an
optimal portfolio
Relationship between risk and return for an
individual security
8. USES OF CAPM
Predict the relationship between the risk
of an asset and its expected return.
The fair return calculated as per CAPM
serves as a standard for comparing it
with expected return
It also helps investor to predict the
return that can be expected from an asset
which is not yet been traded in the
market.
9. CAPM Assumptions:
Individuals are risk averse.
Individual seek to maximise the expected utility of their
portfolios over a single period investment horizon.
Individuals have homogeneous expectations – They have
identical subjective estimates of mean, variances & co-
variance among returns.
The market is perfect.
No taxes.
No transaction or floatation costs.
The quantity of risky securities in the market is given.
Individuals can borrow and lend freely at a riskless rate of
interest.
Securities are completely divisible.
The market is competitive.
11. ALPHA & BETA COEFFICIENT
The intercept of the characteristic
regression line is alpha, i.e. the distance
between the intersection and the
horizontal axis. It indicates that the
stock return is independent of the
market return.
Beta describes the relationship between
the stock return and index return.
12. ARBITRAGE PRICING THEORY
Arbitrage pricing theory was developed by Stephen Ross
on the notion that security returns are not based on single
factor (index) of the market, instead each security is
linked with multiple factors and returns get influenced
by these factors.
Macro economic factors which affect security returns are
growth rate of industrial production, rate of inflation,
spread between long term and short term interest rates.
Securities return differ due o market imperfections, the
investors would make arbitrage profits by selling
security with low return and buying security with high
return.
13. ASSUMPTIONS
1. Capital markets are perfectly
competitive.
2. Investors always prefer more wealth to
less wealth with certainty.
3. The stochastic process generating asset
returns can be expresses as a linear
function of a set of K factors or indices.
Editor's Notes
Finance function refers to all the activities of a company with respect to financial management.