Question

Explain how the homogeneous expectations assumption leads to the conclusion in the Capital Asset pricing Model (CAPM) that the optimal risky portfolio is the market portfolio. Explain between 800 to 1000 words

Answer 1

Homogenous Expectations

Homogenous Expectations means that all the investors will have same expectations and will make the same choices given a particular set of circumstances. In case of homogenous expectations the investors have same expectations regarding inputs used to develop efficient portfolios.

For example

If there are several investment plans with different returns at a particular risk, investors will choose the plan that gives the highest return.

Similarly, if investors are given plans that have different risks but the same returns, investors will choose the plan that has the lowest risk.

Optimal Risk Portfolio

Optimal Risk Portfolio theory assumes that investors will minimizing risk while trying to attain the highest possible return. Therefore this theory assumes investors will act rationally in the given circumstances and will always make decisions with the goal of maximizing return for a given acceptable level of risk.

The out come of Optimal Risk Portfolio is it is possible to have different portfolios with different risk and return. In other words and inverstor can decide how much risk it is willing to take and accordingly they can diversify their portfolio.

The higher the return the higher the risk on the potential of the return and lower the return, lower is the risk on the potential of the return. But the lower return portfolio is the wastage of time. So the optimal risk portfolio is somewhere in between the above mentioned two extremes.

CAPM - Capital Asset Pricing Model

According to the Capital Asset Pricing Model (CAPM) the expected rate of return of a security or a portfolio is equal to the sum of the risk free rate and risk premium.

i.e. Required (or expected) Return = RF Rate + (Market Return – RF Rate)*Beta

Hence the return is minimum when and investor is not taking any risk and invest in risk free securities or portfolios. On the other hand the return is maximum where the investor is making investment in a protfolio with maximum risk. Therefore is an investor is making investment in risk free securities, it is wastage of time and if the investor is making investment in highly risky portfolio then he takes very high risk on the potential of return.

According to CAPM model investor invest in portfolio as per the willingness of the amount of risk he can take.

Market Portfolio

A market portfolio is a bundle of investments that includes every type of asset available in the financial market, with each asset weighted in proportion to its total presence in the market. The expected return of a market portfolio is identical to the expected return of the market as a whole. A market portfolio, by nature is completely diversified, is subject only to systematic risk, or risk that affects the market as a whole, and not to unsystematic risk, which is the risk inherent to a particular asset class.

Hence the rate of return of the market portfolio is sum of risk free rate and risk premium of the portfolio.

Therefore the rate of return of the Market Portfolio is as per the CAPM Model.

Homogenous expectation also consider the systemtic risk in calculating the return on the portfolio and hence it is also in line with the CAPM Model.

Optimal Risk Portfolio also gives return as per the CAPM model i.e. the rate of return of the portfolio is equal to the sum risk free rate and risk premium.

Hence the homogeneous expectations assumption leads to the conclusion in the Capital Asset pricing Model (CAPM) that the optimal risky portfolio is the market portfolio.