Market Theory, Capital Asset Pricing Model

1554 WordsMar 13, 20167 Pages
Capital market has deep developed this century, more and more investors go into this market. Which security is better? How to invest? Investors need numeric index to make decision. There are some theories to help investors: portfolio theory, capital asset pricing model (CAPM), option pricing model and so on. This essay will explain portfolio theory firstly. Secondly, this essay will explain CAPM and discuss the importance of the assumptions of CAPM. Thirdly, this essay will explain arbitrage pricing theory (APT) and factors model. Finally, this essay will compare CAPM with APT and factors model. Harry Markowitz put forward portfolio theory in 1952; portfolio theory is that using portfolio diversification to eliminate non-systematic risk; portfolio theory uses mathematical methods σanalysis the relationship between risk (variance) and expect return (mean) (Brealey, Myers and Allen,2014). Mean-variance criterion is very important for Portfolio theory. The mean is the expect return of portfolio, the formula of expect return for one asset is: E (r) = ∑_(all states)▒〖r×y(states)〗 r is return; y is the probability of return. Formula of expect return for portfolio is: E(r) =w_1*E (r_1) + w_2*E (r_2) + … + w_n*E (r_n) w is the weight of an asset in the portfolio. The variance represents risk of portfolio, and the formula of portfolio’s variance is: σ^2=E [〖(r-¯r)〗^2] = ∑_(i,j=1)^n▒〖w_1 w_2 Cov(r_1,r_2)〗 Cov is the covariance. If there are just two assets, this
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