This week’s movie tutorial has been published for customers. Wecollected topics related to portfolio theory and performancemeasurement into a 1 hour 15 minute review (assigned readings IV. 5, IV6. A & B, and V.6. A & B). Efficient market theory (EMH)anchors traditional portfolio theory, and EMH has three forms:

Whichform does the capital asset pricing model (CAPM) require? As Noel Amencsays, "markets tend to respect the weak or semi-strong form, but theCAPM’s assumption of perfect markets refers in fact to the strong form."(Portfolio Theory and Performance Analysis, 2003). The CAPM pervadesboth of the Stulz readings. The CAPM is described by the securitymarket line (SML) which plots beta against expected return:

Keep in mind the difference between the SML and the capital market line (CML):

• The CML has expected return as a function of portfolio volatility
• The SML has expected return as a function of beta.

Betais the sensitivity of the portfolio to the equity premium (where theequity premium is the expected excess return of the total market inrelation to the riskless rate). In other terminology, beta is calledthe quantity of risk and the equity premium is called the price of risk. So, we could reduce the CAPM to the following phrase: the expected excess return equals the price of risk multiplied by the quantity of risk.
Thenotion of systematic risk exposure is a critical theme in the FRM. TheCAPM claims (under extremely strenuous assumptions) that investors pay only for systematic risk;unsystematic (idiosyncratic) risk is not compensated because it can be"diversified into" the portfolio. This is an opportunity for a firmthat internally bears the costs of financial distress - if the cost offinancial distress (e.g., the costs of the threat of bankruptcy) is anunsystematic risk that can be "outsourced" to shareholders, then valuecan be created. That’s because: what is costly for the firm (financialdistress) is inexpensive for shareholders, who can diversify it away.

Ofcourse, the CAPM is a single factor model (i.e., the single factor isthe equity premium - beta isn’t really the factor, it is the sensitivity tothe factor) and therefore a special case of multi-factor models. Thoseare categorized into economic, fundamental and statistical: