Sunday, November 29, 2009


Portfolio Theory and Asset Pricing Models

The portfolio is a bundle or a combination of individual asset or securities. The portfolio provides a normative approach to investors to make decisions to invest their wealth in asset or securities under risk. It is based on the assumption that investors are risk averse.

This implies that investors hold well diversified portfolios instead of investing their entire wealth in a single or a few assets.

One important conclusion of the portfolio theory is that if the investors hold a well diversified portfolio of assets, then their concern should be the expected rate of return and risk of the portfolio rather than individual assets and the contribution of individual asset to the portfolio risk.

The second assumption of the portfolio theory is that the returns of the assets are normally distributed. This means that the expected value and variance or standard deviation analysis is the foundation of the portfolio decisions.

Further we can extend the portfolio theory to derive a framework for valuing risky assets. This framework is referred to as the capital asset pricing model (CAPM). An alternative model for the valuation of risky assets is the arbitrage pricing theory (APT).

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