Capital market theory
Capital market theory is a framework for explaining how risk and expected return are related in the securities markets. It builds on modern portfolio theory and includes concepts like the capital asset pricing model (CAPM), beta, and the efficient frontier.
Capital market theory is the body of ideas that describes how investors price risk in the capital markets. It extends modern portfolio theory — Harry Markowitz's insight that diversification lets investors maximize expected return for a given level of risk — into a broader model of how all risky assets should be priced relative to one another.
Its centerpiece is the capital asset pricing model (CAPM), which states that an asset's expected return equals the risk-free rate plus a risk premium based on the asset's beta. In formula terms: expected return = risk-free rate + beta × (market return − risk-free rate). Beta measures an asset's sensitivity to overall market movements, so a stock with a beta of 1.5 is expected to move 50% more than the market in either direction.
A key implication is that investors are only compensated for taking systematic risk — the market-wide risk that cannot be diversified away. Nonsystematic (company-specific) risk can be eliminated by holding a diversified portfolio, so the market offers no extra return for bearing it. Related concepts include the efficient frontier (the set of portfolios offering the best return for each level of risk) and alpha (return earned above what CAPM predicts).
Capital market theory appears throughout the Series 65 and Series 66 exams, which test CAPM calculations, the meaning of alpha and beta, the difference between systematic and nonsystematic risk, and how these tools inform investment recommendations and portfolio construction.
Key takeaways
- Capital market theory explains the relationship between risk and expected return, building on modern portfolio theory.
- CAPM is its central model: expected return = risk-free rate + beta × (market return − risk-free rate).
- Investors are compensated only for systematic risk; nonsystematic risk can be diversified away.
- Alpha measures performance above or below the return CAPM predicts for a given beta.
- The Series 65 and Series 66 exams test CAPM, alpha, beta, and the efficient frontier.