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.

The One-Liners That 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.
• On the Security Market Line (SML): above = undervalued (buy), on = fairly valued, below = overvalued (sell). "Above" sounds like overpriced but means the opposite.
• 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).
• The efficient frontier holds only the best portfolios: highest return for each level of risk. Everything below it is suboptimal.
• EMH progression: weak kills technical analysis, semi-strong kills technical and fundamental, strong kills everything including insider edges.
• If markets are efficient in any form, passive investing (index funds) is the rational strategy.
• Market anomalies challenge EMH but do not disprove it.

Capital Asset Pricing Model (CAPM)

• 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).
• Example: 4% + 1.2 x (10% - 4%) = 4% + 7.2% = 11.2%.
• Beta reading: 1.0 moves with the market; above 1.0 is more volatile; below 1.0 is less volatile; 0 has no market correlation; negative moves opposite.
• 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.

Modern Portfolio Theory (MPT)

• Developed by Harry Markowitz (published 1952, Nobel Prize 1990); William Sharpe developed CAPM (1964).
• 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 per unit of risk; it curves up and to the right (standard deviation on the x-axis, expected return on the y-axis).
• Adding low-correlation assets shifts the efficient frontier left (less risk) and/or up (more return).
• Assumptions: rational risk-averse investors deciding on risk and return only, efficient markets with shared information, normally distributed returns, and stable correlations (a known limitation, since correlations rise in real crises).

Efficient Market Hypothesis (EMH)

• 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 it is illegal). Widely accepted as a reasonable 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.

Numbers to Lock In

Top Gotchas

• 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.
• Semi-strong kills BOTH technical and fundamental analysis. Remember the progression: weak kills technical only, semi-strong adds fundamental.
• Strong form means even insider information cannot help, and it is theoretical, not empirically supported.
• A correlation of +1.0 gives zero benefit, not maximum. Lockstep assets give you nothing.
• CAPM equals beta, Sharpe and MPT equal standard deviation. Do not mix up the risk measures.
• The market risk premium is (Rm minus Rf), not Rm alone.

Memory Aid: WeSS for the Three EMH 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 (CAPM) prices individual assets on systematic risk (beta) using Expected Return = Rf + beta x (Rm minus Rf), where the Security Market Line flags anything above it as undervalued and below it as overvalued. Modern Portfolio Theory (MPT) shifts to the whole portfolio, measuring total risk by standard deviation and building the efficient frontier by combining low-correlation assets so diversification strips out unsystematic risk while systematic risk stays. The Efficient Market Hypothesis (EMH) 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. Lock in CAPM equals beta, MPT and Sharpe equal standard deviation, above the SML equals undervalued, and the WeSS progression, and this unit answers itself.

Need more than the recap? This is a condensed summary. If it is not enough, read the full Capital Market Theory unit for the complete lesson.