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CAPM can trace its development from Portfolio Theory (i
CAPM can trace its development from Portfolio Theory (i.e. the two fund separation theorem) which shows that the process of optimizing the return/risk ratio will ensure that every investor will invest in a portfolio of risk free asset and the risky market portfolio (also known as the two fund separation theorem). Explain and illustrate with a graph why no one will invest in other risky portfolios other than the market portfolio. Why would every tradable asset in the market be included in this market portfolio?
Expert Solution
CAPM traces its development from modern portfolio theory which assumes that investors are rational and market are efficient.
Efficient markets imply that all market participants have all the information necessary to make an investment decision. Thus, nobody can outperform the market on a consistent basis. Thus, under CAPM, no one will invest in other risky portfolios other than CAPM.
The special property of market portfolio is that it produces highest return for a given level of risk. It is the straight line tangent to the efficient frontier.
The below shows the capital market line graphically.
please see the attached file
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