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Modern Portfolio Theory

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The efficient frontier theory argues that portfolios made up of just one asset are inefficient – the better performing portfolios would always turn out to be the ones that are efficiently diversified – except when no other portfolio of assets can deliver a higher expected return with equal risk or lower risk with an equal or higher return. Based on the Markowitz portfolio theory, the existence of the risk-free asset has been assumed.   A risk-free asset is one with zero variance.   The expected rate of return on it is always produced or delivered, so the risk or the standard deviation on the returns thereof is always equal to zero.   Even the covariance and the correlation coefficient of portfolios that include a risk-free asset would then be computed as zero.   (p.

280) Based on Markowitz’ s portfolio theory, two major theories were proposed as models for valuing risky assets:   namely, the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT). CAPM is the model that specifies what should be the expected or the required rate of returns on a risky asset, based on the risks it is exposed to (Reilly & Brown, 1997, p.

287).   It is seen to continue to be a reliable model for pricing capital assets. Thus, it is useful in finding out whether assets at their given market prices are overpriced, underpriced or priced just right.   Tests have shown that CAPM is helpful in learning more about the manners and ways by which the investment world moves and makes decisions.   There are prevailing arguments against it, though, due to its underlying assumption that investors have quadratic utility functions and that the market prices of securities can reasonably be projected.   In the real world, the market prices of securities follow no pattern or trend that can ever be successfully pre-determined.

In light of these arguments, Stephen Ross came up with the Arbitrage Pricing Theory (APT).   APT is based on the assumptions that “ capital markets are perfectly competitive, ” and that investors will always choose to earn more than to earn less from their investments.      

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