ABSTRACT
In Chapter 4, we discuss Modern Portfolio Theory and the Capital Asset Pricing Model (CAPM). Modern portfolio theory which was developed by Markowitz (1952) considers the movement of risky assets as random variables. The expected value of the prices of risky assets is considered as return and the variance of their prices is considered as risk. Modern portfolio theory leads to many useful results, one of which is CAPM, developed by Lintner (1965), Sharpe (1964) and Mossin (1966). CAPM assumes a linear relationship between the return of each stock and the return of the stock market. CAPM is now a basic concept for trading in the stock market, and is commonly used in formulating trading strategies, such as pair trading. The simple structure of CAPM is one of the attractive features of this theory. However, the derivation of CAPM requires a slightly complicated procedure. We briefly show this procedure and some features of modern portfolio theory and CAPM.
