Thursday, September 12, 2019

A central assumption made in Mean-Variance Analysis and the Capital Coursework

A central assumption made in Mean-Variance Analysis and the Capital Asset Pricing Model (CAPM) is that investors prefer to invest in the most efficient portfolios available - Coursework Example The concept of the efficient portfolio can be well understood after revisiting the preceding portfolio management theories. One such theory is the famous capital assets pricing theory (CAPM). The CAPM is a model that shows the association between the required rate of return and the risk on assets that are held in a portfolio that is well diversified. According to Fama and French (2004), the origin of the capital asset pricing model is the prominent work of William Sharpe (1964) and John Lintner (1965). The CAPM model is very useful in activities such as the determination of the companies’ cost of capital and in assessing portfolio performance. A portfolio is a group of assets (more than one asset) held by an investor (Sharpe 1964). The theory of portfolio attempts to guide investors on how to make the best combination of assets to optimise returns as well as minimise the risk associated with the investments. The commonly used CAPM equation is a follows: ER = Rf + (Rm – Rf)ÃŽ ², where Rf is the risk free rate, ER is the expected return on the portfolio, (usually denoted by the interest rate on treasury bills), Rm is the expected market return for the same period, and ÃŽ ² is the beta, which measures the relationship between the portfolio performance and the market performance. In other words, beta indicates how sensitive the portfolio’s performance is to the variations in the market performance. The above equation shows that a portfolio’s return can be expressed in terms of the risk-free return, the risk premium and the beta. Based on the equation, which is a linear, it is revealed that the portfolio return is directly related to the risk. That is, the higher the portfolio risk, the higher the portfolio’s return. The CAPM theory brings us to another idea of the efficient portfolio. A portfolio can be efficient under

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