Modern Portfolio Theory Free Essay Example, 1500 words

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 sp ecifies 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. We will write a custom essay sample on Modern Portfolio Theory or any topic specifically for you Only $17.96 $11.86/page 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.