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1. Question 2 (10 Marks)
Discuss the statement with reference to the “efficient frontier”, CAPM and Modern Portfolio Theory (MPT). In your discussion make comparisons, of the CAPM and MPT models with reference to the merits of each.
Both the CAPM and MPT provide a mathematical model for minimizing market risk in any investment portfolio (Jarvis & Mandell 2003, p. 95). Below we will elaborate the topic with review and discussion to the two models.
First of all let’s look at the concept of Modern portfolio theory (MPT). The Modern Portfolio Theory (MPT) is an investment theory that demonstrates how risk-averse investors can construct portfolios that best maximize expected returns on the basis of a specific level of market risk while emphasizing the risk is inevitable when one is seeking higher returns (Guinan 2009). And based on this theory, we can build an efficient frontier of a set of optimal portfolios which provides the maximum possible anticipated returns for a given levels of risk (Bluemke 2009). And the Modern portfolio theory (MPT) tries to quantify the risk control the risk to a certain level for the overall portfolios by diversification of the portfolios which contains a set of assets and each asset will have an anticipated return together with risk (Markowitz 1952).
Formula 3 CAPM calculation formula
Source: Rezaee 2001, p.358
Another closely related Capital asset pricing model (CAPM) which is based on capital market theory describes how investors must behave when selecting a particular security (eg, common stocks) for their portfolios under a given set of assumptions such as the risk level (Rezaee 2001, p. 358). The model is constructed based on the homogeneous expectations assumption and implies that individual investors attempt to optimize their portfolios. The capital asset pricing model gives the nature of the relationship between the expected return and the systematic risk of a security. The Capital asset pricing model (CAPM) is part of the Modern Portfolio Theory (MPT) which expands the MPT concept of risky assets and efficient frontier. And looking into CAPM model developed by Sharpe, the model extended MPT to include the concept of a risk-free asset together with assumption that investors can borrow or lend at a risk-free rate. Hence a portfolio’s risk can be divided into systematic risk and unsystematic risk. Based on this model, only systematic risk is relevant which is measured by the beta factor (Bradfield 2007, p. 201).