Abstract
The assumptions about the capital market theory expands on to that of the Markowitz portfolio model, and includes consideration of the risk-free rate of return. The correlation and covariance of any asset with a risk-free asset is zero, so that any combination of an asset or portfolio with the risk-free asset generates a linear return and risk function. Therefore, when you combine the risk-free asset with any risky asset on the Markowitz efficient frontier, you derive a set of straight-line portfolio possibilities. The dominant line is the one that is tangential to the efficient frontier. This dominant line is referred to as the capital market line (CML), and all investors should target points along this line depending on their risk preferences. Since all investors want to invest in the risky portfolio, this portfolio, referred to as the market portfolio, must contain all risky assets in proportion to their relative market values. Moreover, the investment decision and the financing decision can be separate because, although everyone will want to invest in the market portfolio, investors will make different financing decisions about whether to lend or borrow based on their individual risk preferences. Given the CML and the dominance of the market portfolio, the relevant risk measure for an individual risky asset is its covariance with the market portfolio, that is, its systematic risk. When this covariance is standardized by the covariance for the market portfolio, we derive the well-known beta measure of systematic risk and a security market line (SML) that relates the expected or required rate of return for an asset to its beta measure.
