Asset Pricing Models
Sony Thomas

Capital Market Theory: An Overview
• Capital market theory extends portfolio theory and develops a model for pricing all risky assets • Capital asset pricing model (CAPM) will allow you to determine the required rate of return for any risky asset

Assumptions of Capital Market Theory
1. All investors are Markowitz efficient investors who want to target points on the efficient frontier.

Assumptions of Capital Market Theory
2. Investors can borrow or lend any amount of

money at the risk-free rate of return (RFR).

Assumptions of Capital Market Theory
3. All investors have homogeneous expectations; that is, they estimate identical probability distributions for future rates of return.

Assumptions of Capital Market Theory
4. All investors have the same one-period time horizon such as one-month, six months, or one year.

Assumptions of Capital Market Theory
5. All investments are infinitely divisible, which means that it is possible to buy or sell fractional shares of any asset or portfolio.

Assumptions of Capital Market Theory
6. There are no taxes or transaction costs involved in buying or selling assets.

Assumptions of Capital Market Theory
7. There is no inflation or any change in interest rates, or inflation is fully anticipated.

Assumptions of Capital Market Theory
8. Capital markets are in equilibrium.

Risk-Free Asset
• • • • An asset with zero standard deviation Zero correlation with all other risky assets Provides the risk-free rate of return (RFR) Will lie on the vertical axis of a portfolio graph

Covariance with a Risk-Free Asset
Covariance between two sets of returns is n i 1

Cov ij   [R i - E(R i )][R j - E(R j )]/n

Because the returns for the risk free asset are certain,

 RF  0

Thus Ri = E(Ri), and Ri - E(Ri) = 0

Consequently, the covariance of the