Capital Market Theory tries to explain and predict the progression of capital (and sometimes financial) markets over time on the basis of the one or the other mathematical model. Capital market theory is a generic term for the analysis of securities.
In terms of tradeoff between the returns sought by investors and the inherent risks involved, the capital market theory is a model that seeks to price assets, most commonly, shares.
In general, whenever someone tries to formulate a financial, investment, or retirement plan, he or she (consciously or unconsciously) employs a theory such as arbitrage pricing theory, capital asset pricing model, coherent market hypothesis, efficient market hypothesis, fractal market hypothesis, or modern portfolio theory.
The most talked about model in Capital Market Theory is the Capital Asset Pricing Model.
In studying the capital market theory we deal with issues like the role of the capital markets, the major capital markets in the US, the initial public offerings and the role of the venture capital in capital markets, financial innovation and markets in derivative instruments, the role of securities and the exchange commission, the role of the federal reserve system, role of the US Treasury and the regulatory requirements on the capital market.
Capital Market Theory sets the environment in which securities analysis is preformed. Without a well-constructed view of modem capital markets, securities analysis may be a futile activity. A great debate, and great divide, separates the academics, with their efficient market hypothesis, and the practitioners, with their views of market inefficiency. Although the debate appears surreal and unimportant at times, its resolution is immensely critical for conducting effective securities analysis and investing successfully.
The CAPM is commonly confused with portfolio theory. Portfolio theory is simply the use of statistical and mathematical programming techniques to derive optimal tradeoffs between risk and return. Under very restrictive assumptions (rarely found in financial markets), the CAPM is a highly specialized subset of portfolio theory. Even so, the CAPM has become very popular as it provides a logical, common sense tradeoff between risk and return.
Risk-free asset is an asset, which has a certain future return. In other words, a risk-free asset is one for which there is no uncertainty regarding the future returns; that is, the investor knows exactly what the value of the asset will be at the end of the holding period. Thus, variance of returns of a risk-free asset is equal to zero. A good example of such asset is government bonds.
Risk-Free Lending and Borrowing
Investing in a risk-free asset is frequently referred to as `risk-free lending’, since investment in such assets tantamount to giving loan directly to the government. An investor does not have to depend solely on his own wealth to decide how much to invest in assets. She/he can borrow and invest, i.e., the investor can use financial leverage. However, investor will have to pay interest on borrowed funds and such borrowing is also assumed to have same risk-free interest rate and hence deemed as “risk-free borrowing”. Though it may not be practical for an ordinary investor to borrow at risk-free interest rate, it is quiet possible for large funds to borrow at a rate close to risk-free rate.
The risk-free rate is assumed to be 5%, and a tangent line-called the capital market line-has been drawn to the efficient frontier passing through the risk-free rate. The point of tangency corresponds to a portfolio on the efficient frontier. That portfolio is called the “super-efficient” portfolio. The Capital Asset Pricing Model demonstrates that, given certain simplifying assumptions, the super-efficient portfolio must be the market portfolio.
Using the risk-free asset, investors who hold the super-efficient portfolio may:
- Leverage their position by shorting the risk-free asset and investing the proceeds in additional holdings in the super-efficient portfolio.
- Deleverage their position by selling some of their holdings in the superefficient portfolio and investing the proceeds in the risk-free asset.
The Capital Market Theory deals with the following issues:
- Importance of venture capital in the capital market
- Initial public offerings
- Role of capital market
- Major capital markets worldwide
- Markets and financial innovations in derivative instruments
- Role of Federal Reserve System
- Role of securities
- Capital market regulatory requirements
- Role of the government treasury
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