Market Portfolio

Definition

The market portfolio is a theoretical portfolio that represents all the investable assets in the market, weighted by their market capitalization. It is a key concept in the Capital Asset Pricing Model (CAPM) and the evaluation of the costs of debt and equity capital.

5 Must Know Facts For Your Next Test

1. The market portfolio is a theoretical construct that includes all risky assets in the market, weighted by their market capitalization.
2. In the CAPM, the market portfolio is the optimal portfolio for an investor to hold, as it represents the most efficient risk-return trade-off.
3. The market portfolio is used to calculate the expected return of an asset, based on its sensitivity (beta) to the market's movements.
4. The market portfolio is a key component in the calculation of the cost of equity capital, as it represents the expected return on the market as a whole.
5. The Efficient Market Hypothesis (EMH) assumes that the market portfolio is the true market portfolio, and that asset prices fully reflect all available information.

Review Questions

• Explain how the market portfolio is used in the Capital Asset Pricing Model (CAPM) to determine the expected return of an asset.
  • In the CAPM, the market portfolio represents the optimal portfolio that all investors should hold. The model uses the market portfolio's expected return and the asset's sensitivity to the market, measured by its beta, to calculate the asset's expected return. Specifically, the CAPM states that the expected return of an asset is equal to the risk-free rate plus the asset's beta multiplied by the difference between the market portfolio's expected return and the risk-free rate. This relationship allows investors to determine the appropriate required return for an asset based on its level of systematic risk.
• Describe the role of the market portfolio in the evaluation of the cost of debt and equity capital.
  • The market portfolio is a crucial component in the evaluation of the cost of debt and equity capital. For the cost of equity capital, the market portfolio's expected return is used as the benchmark for the required return on equity. The CAPM is commonly used to estimate the cost of equity, where the market portfolio's expected return represents the expected return on the market as a whole. Similarly, the market portfolio's expected return is used to calculate the equity risk premium, which is a key input in the weighted average cost of capital (WACC) formula. The WACC, in turn, is used to determine the overall cost of capital for a firm, which is essential for evaluating investment decisions and the firm's capital structure.
• Analyze how the Efficient Market Hypothesis (EMH) relates to the concept of the market portfolio.
  • The Efficient Market Hypothesis (EMH) and the market portfolio are closely linked. The EMH assumes that asset prices fully reflect all available information, and that investors cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis. This implies that the market portfolio, which represents all investable assets weighted by their market capitalization, is the true market portfolio. In an efficient market, the market portfolio would be the optimal portfolio for investors to hold, as it represents the most efficient risk-return trade-off. The EMH also assumes that investors cannot outperform the market portfolio, as all available information is already reflected in asset prices. Therefore, the market portfolio is a central concept in the EMH, as it represents the benchmark against which all investment performance is measured.

Related terms

Capital Asset Pricing Model (CAPM): A model that describes the relationship between the expected return and risk of an asset, based on the market portfolio and the asset's sensitivity to market movements.

Efficient Market Hypothesis (EMH): The theory that asset prices fully reflect all available information, and that investors cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis.

Beta: A measure of an asset's sensitivity to the movements of the overall market, which is used to calculate the asset's expected return in the CAPM.