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Capital Market Theory Definition and Quiz

The wide adoption of computing power in the late 1950s and early 1960s gave scholars the ability to think about asset allocation in a whole new and scientific way.
  1. Define - Define Capital Market Theory.
  2. Context - Use it in a sentence.
  3. Quiz - Test yourself.
face pic by Paul Alan Davis, CFA
Updated: February 17, 2021
Sometimes Capital Market Theory is confused with Modern Portfolio Theory, so here we'll clear that up.

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Capital Market Theory for Portfolio Management

Intermediate

Capital Market Theory is the theory developed in the 1960s and made popular by William Sharpe. It piggybacked on Modern Portfolio Theory but added a risk-free asset to portfolio mix. This allowed investors to build portfolios with two components: the risk-free asset, like Treasury Bills, and a Market portfolio which maximizes the return-over-risk ratio of all risky assets. This changed portfolio choice from the efficient frontier to the straight line from the risk-free rate to the Market portfolio, and the concept of multi-asset-class allocation was born.

Synonym: CMT

For context, the slope of the resulting Capital Market Line can be used to find the return-to-risk relationship of any portfolio, given someone took the time to properly forecast rate of return and risk expectations. In the real world, large investment firms are more inclined to go through this process because they understand portfolio theory better than most individual investors.

In most cases risk is measured by standard deviation.

In a Sentence

Doc:  Who else was working independently on the Capital Market Theory?
Mia:  I know! Jack Treynor, John Lintner and Jan Mossin.

Video

Many terms have 4-5 minute videos showing a derivation and explanation. If this term had one, it would appear here.

Videos can also be accessed from the YouTube Channel.

Video Script

If this term had a video, the script would be here.

Quiz

Click box for answer.

What is a byproduct of The Federal Reserve lowering interest rates? This action theoretically ____ the reward-to-risk ratio for investors. | Decreases or Increases?

Increases

What is the risk expectation of a portfolio allocated 40% to T-bills yielding 0%, and 60% to a Market Portfolio with an expected return of 8%, and a Sharpe Ratio of 0.50? | 2.4%, 4.6%, 6.4% or 9.6%?

9.6. It is the product of the allocation of 60% times risk of 16%.

Questions and Comments?

Still unclear on the Capital Market Theory? Try out the course Quant 101 and specifically the tutorial with video called Ace Your Portfolio Theory Exam.

Related Terms

Our trained humans found other terms in the category academic works you may find helpful.

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capital market theory
cmt in finance
william sharpe
modern portfolio theory
mpt in finance
risk free asset
market portfolio
maximize return
risk adjusted return
portfolio choice
efficient frontier
stock valuation
portfolio theory
asset allocation

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