Understanding Investment

What is Capital Market Theory?

What is Capital Market Theory? Types and Importance of Capital Market Theory

Capital Market Theory tries to explain and predict the progression of capital (and sometimes financial) markets overtime on the basis of the one or the other mathematical model. 

Capital Market Theory tells the investor how assets should be priced in the capital markets under the light of portfolio theory. 

The theory that describes the pricing mechanism of capital assets in the market is defined as Capital Market Theory.

Investors and concerned wish to examine a model that explains security prices under the condition of market equilibrium. One equilibrium model known as CAPM (Capital Asset Pricing Model) is commonly used in determining the prices of capital assets. 

The CAPM was developed in the early 1960s by economists John Lintner, Jack Treynor, William Sharpe, and Jan Mossin.

The model is an extension of the earlier work of Harry Markowitz on diversification and modern portfolio theory.

William Sharpe later received the Nobel Prize in economics along with Merton Miller and Markowitz for their further contributions to CAPM-based theory.

Assumptions of Capital Market Theory

The following assumptions apply to the base theory:

  • All investors are risk-averse by nature.
  • Investors have the same time period to evaluate information.
  • There is unlimited capital to borrow at the risk-free rate of return.
  • Investments can be divided into unlimited pieces and sizes.
  • There are no taxes, inflation or transaction costs.

Due to these premises, investors choose mean-variant efficient portfolios, which by name seek to minimize risk and maximize return for any given level of risk.

In studying the capital market theory we deal with issues like the role of the capital markets, the major capital markets in the US, the initial public offerings and the role of venture capital in capital markets, financial innovation and markets in derivative instruments, the role of securities and the exchange commission, the role of the federal reserve system, the role of the US Treasury and the regulatory requirements on the capital market.

The Theory deals with the following issues:

  • Importance of venture capital in the capital market
  • Initial public offerings
  • Role of capital market
  • Major capital markets worldwide
  • Markets and financial innovations in derivative instruments
  • Role of the Federal Reserve System
  • Role of securities
  • Capital market regulatory requirements
  • Role of the government treasury

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