Financial Risk Manager Part 1

The risk premium, according to the Capital Asset Pricing Model (CAPM), increases directly with beta. Beta is a measure of a stock's systematic risk, or the sensitivity of the stock's returns to changes in the market. A beta of 1 indicates that the stock's price will move with the market, while a beta less than 1 indicates that the stock will be less volatile than the market, and a beta greater than 1 indicates that the stock will be more volatile than the market. Therefore, a higher beta implies a higher risk, and investors require a higher risk premium for taking on this additional risk. This is consistent with the fundamental principle of finance that higher risk requires higher return as compensation. Therefore, as beta increases, the risk premium expected by a stockholder also increases directly.

Choice B is incorrect. The risk premium does not change inversely with beta. According to the CAPM, the risk premium (the expected return above the risk-free rate) of a security increases as its beta (systematic risk) increases. Therefore, there is a direct relationship between beta and the expected risk premium, not an inverse one.

Choice C is incorrect. The statement that the risk premium changes inversely with systematic risk contradicts CAPM's fundamental principle. Systematic Risk, represented by Beta in CAPM, directly influences the Risk Premium - higher systematic risks lead to higher expected returns or premiums and vice versa.

Choice D is incorrect. According to CAPM, it's not total risk but rather systematic or market-related risks (beta) that influence a security's expected return or Risk Premium directly. Total Risk includes unsystematic risks which can be diversified away and hence do not contribute towards earning additional premiums.