Capital Market Theory

The whole unit on one sheet: the three models, the risk measure each one uses, and the distinctions the Series 66 tests most.

Which One-Liners Win Points?

• CAPM uses beta (systematic risk); the Sharpe ratio and MPT use standard deviation (total risk). Knowing which model uses which measure is the single most tested distinction.
• Only systematic risk is rewarded. Unsystematic (company-specific) risk earns no premium because diversification removes it.
• Market risk premium is (Rm minus Rf), not just Rm. Subtract the risk-free rate first.
• Diversification eliminates unsystematic risk, never systematic risk. No portfolio can diversify away market-wide risk.
• Correlation of +1.0 gives zero diversification benefit; -1.0 gives maximum benefit (risk can be fully eliminated).
• EMH progression: weak kills technical analysis, semi-strong kills technical and fundamental, strong kills everything including insider edges.
• If markets are efficient at the semi-strong level or above, passive investing (index funds) is the rational strategy (weak-form efficiency alone still leaves fundamental analysis potentially useful).

What Does the Capital Asset Pricing Model Price?

• Links systematic risk (beta) to expected return; investors are compensated only for market risk.
• The formula, verbatim:

• Components: risk-free rate (Rf, typically U.S. Treasury bills), beta (sensitivity to market moves), market return (Rm), and the market risk premium (Rm minus Rf).
• Beta reading: 1.0 moves with the market; above 1.0 is more sensitive to market moves; below 1.0 is less sensitive; 0 has no systematic market sensitivity; negative moves opposite. Beta measures only sensitivity to the market, not total volatility, so a low-beta security can still swing a lot from company-specific factors.
• The Security Market Line (SML) is CAPM graphed (expected return on the y-axis, beta on the x-axis), starting at the risk-free rate and sloping up.
• Key assumptions: rational risk-averse investors, efficient markets (no costs or taxes), shared horizon and expectations, borrowing and lending at the risk-free rate, and only systematic risk rewarded.

What Does Modern Portfolio Theory Measure?

• Developed by Harry Markowitz (Nobel Prize 1990); William Sharpe is the leading developer of CAPM (alongside parallel contributions by Treynor, Lintner, and Mossin).
• Core principle: diversification can reduce portfolio risk without necessarily reducing expected return.
• Risk is measured by standard deviation (total risk), because MPT is building the whole portfolio.
• Lower correlation means greater risk reduction. Combining low or negatively correlated assets cuts overall volatility.
• The efficient frontier is the set of portfolios giving the highest expected return for a given level of risk (or the lowest risk for a given return); it curves up and to the right (standard deviation on the x-axis, expected return on the y-axis).
• Adding low-correlation assets can shift the efficient frontier left (less risk) and/or up (more return), though whether it actually does depends on that asset's own return, risk, and weight in the portfolio.
• Assumptions: rational risk-averse investors deciding on risk and return only, normally distributed returns (so mean and standard deviation fully describe risk/return), and (for estimation) stable correlations (a known limitation, since correlations rise in real crises).

What Does Each Form of the Efficient Market Hypothesis Rule Out?

• States that security prices fully reflect all available information, so consistently beating the market is impossible; developed by Eugene Fama in the 1960s.
• Weak form: prices reflect all past market data; technical analysis is useless, but fundamental analysis may still work.
• Semi-strong form: prices reflect all public information; both technical and fundamental analysis are useless; only insider information could give an edge (and trading on material nonpublic information is generally illegal). Often treated as a reasonable working approximation of developed markets.
• Strong form: prices reflect all information, public and private; no one, not even insiders, can earn excess returns. Most extreme and generally NOT supported by empirical evidence.
• Market anomalies (January effect, small-firm effect, value effect, momentum) challenge EMH but do not disprove it; they may reflect extra risk, data mining, or temporary inefficiencies.

Which Numbers Matter Most?

Which Gotchas Trip Students Up?

• An asset above the SML is undervalued, not overvalued. Counterintuitive but heavily tested.
• Weak form does NOT invalidate fundamental analysis; it only kills technical analysis.

What Is the Memory Aid for the Three Forms?

• Weak = historical data only (kills Technical)
• Semi-Strong = all public info (kills Technical plus Fundamental)
• Strong = all info including insider (kills everything)

One-Breath Recap

Capital market theory rests on three models and one recurring question: which risk measure does each use? The Capital Asset Pricing Model prices individual assets on systematic risk (beta) as risk-free rate plus beta times the market premium, and the Security Market Line flags anything above it as undervalued, below it as overvalued. Modern Portfolio Theory shifts to the whole portfolio, measuring total risk by standard deviation and building the efficient frontier from low-correlation assets, so diversification strips out unsystematic risk while systematic risk stays. The Efficient Market Hypothesis then asks whether you can beat the market at all: weak form kills technical analysis, semi-strong kills technical and fundamental, and strong form kills even insider edges.

Need more than the recap? Read the full Capital Market Theory unit.