Question

Briefly discuss Capital Market Theory and how it differs from Markowitz Theory.Briefly discuss Capital Market Theory and how it differs from Markowitz Theory.

Answer 1

Capital market theory proposes to understand the relationship between the return achieved from the investment or portfolio and risk. It shows with the use of capital market line, that as the risk of the security increases, the return expectation also increases. Or, a security with higher return, comes at a higher risk. For example, private equity has the highest risk, but has highest return as well. Hence, capital market theory can be used to build a portfolio that has securities with comparable returns, but the portfolio has lower risk. It is different from the Markowitz theory, that takes an assumption that investors are risk averse and they always demand lowest risk at a particular return level. Hence, Markowitz theory works to prepare an efficient frontier. At that efficient frontier line, all portfolios will have the lowest risk at a particular return level. Though, it is not done with the capital market theory.