While modern portfolio theory (MPT) is about the portfolio schedule, the capital asset pricing model (CAPM) enables you to set the entire market’s pricing. There are several components in both the theory and the model. Do you know about all of them? If not, James Forjan has explained about MPT and CAPM in this AnalystPrep article.
Gathering Knowledge on MPT and CAPM
What Do You Assume for MPT?
According to the modern portfolio theory, you have an ‘ideal market’ when you do not need to pay tax and pay for your purchases. The competition is healthy and agreeable to all. While working on the theory, Harry Markowitz remarked that your investment size should be the asset’s contribution for the return you get for the portfolio. Markowitz Efficient Frontier marks the maximum return for each risk.
What Are Your Theories on CAPM?
The trio—Sharpe, Lintner, and Mossin—developed the model to keep the market’s equilibrium intact. The capital asset pricing model assumes there are no transaction expenses or taxes. You can divide assets into indefinite fragments with limitless short-selling options. You can market or liquidate all assets. No matter the price in which investors deal in, it does not affect your singular buy-and-sell transactions. Your only concerns are risks and single-period returns.
CAPM Derivation
- When you invest, you get compensation only for ‘systematic risk’.
- If the portfolio expected return and portfolio beta are averages of specific expected returns and specific betas, the portfolio return is a ‘linear function’ of portfolio beta.
- You can then calculate the expected rate of return using assets sans risks and market portfolios.
More About The Two Concepts
Forjan has talked further about capital market line, single-index performance measurement indicators like Sharpe Performance Index (SPI), Treynor Performance Index (TPI), and Jensen Performance Index (JPI). He elaborated on the relationship between TPI and JPI. The tracking error (TE), information ratio (IR), Sortino Ratio (SR) are other such topics you can relate to CAPM.
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