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Capital Markets Theory: The Concept Of Capital Market Theory

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CAPITAL MARKET THEORY
The Concept of Capital Market Theory is that it tries to describe and evaluate the advancement of capital and likewise financial market over a certain period of time.
The Capital Market Theory in general tries to clearly define and foresee the development and advancement of capital. It is also known to be a common term that is used for the study of securities. In terms of the relationship between rate of returns seeked by all investors and likewise the inheritance of risk that comes along.
The main purpose of this capital market theory model is that seeks to “price assets” but more popularly “shares” among investors. In all-purposes if an individual is to generate an investment in a company or a retirement plan that …show more content…

The mechanism of finance in this market has large maturity periods. The insecurity and inaccurate prediction on the expected rate of returns or even possibility of losses in an investment is defined as “risk” in financial terms.

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The Capital Market Theory was created upon the Markowitz Portfolio Model. Their crucial and important assumptions of the above mentioned theory are as follows;
• All investors are resourceful investors- Investors follow Markowitz idea of the efficient frontier and thus prefer to invest in ranges of and along the boundary.
• Investors borrow/lend money at risk-free rates- These risk-free rates are fixed at any point of time
• No inflation exists- These returns seeked by investors are not at all affected by the inflation rate in the country within the capital market as it is fictional and does not exist in the capital market theory concept.
• All investors have the same probability for outcome- Predicting the expected rate of return each investor have identical probability for an outcome.
• All assets are infinitely divisible- This states that the insignificant purchasing of shares and stocks are considerably …show more content…

The basic view and expectation of such a model is how investors investing in the market need to be rewarded. Which are; (1) Time value of money and (2) Risk.
FORMULA:

Explanation:
The Time value of money by the risk-free (rf) rate in the formula and reimburses the investors for placing money in any investment over a period of time. The second part of the formula shown above describes or calculates risk and the total sum of reward the investors seek for taking extra risks. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).
Example:
The present risk free-rate is 5%, S&P 500 is likely to yield to 12% next year. You therefore intend to calculate the rate of return JOB will have next year. You hence substitute the beta value, 1.9 into the formula. The whole market employs a beta value of 1.0, and therefore JOBS beta of 1.9 clearly indicates that it transmits extra risk than the overall market; and hence we should expect high returns exceeding 12% of S&P 500. R = 5% + 1.9 (12% -

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