Financial Risk Manager Part 1
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According to CAPM, which of the following risks should an investor be compensated for?
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TTanishq
A
Systematic risk only.
B
Unsystematic risk only.
C
Both systematic and unsystematic risk.
D
Both systematic risk and asset-specific risk.
Explanation:
Explanation
The Capital Asset Pricing Model (CAPM) states that investors should only be compensated for systematic risk (also known as market risk or non-diversifiable risk). Here's why:
Key Concepts:
- Systematic Risk: Risk that affects all companies in the market and cannot be eliminated through diversification (e.g., interest rate changes, inflation, recessions, political instability)
- Unsystematic Risk: Risk specific to individual companies or industries that can be eliminated through diversification (also called specific risk, diversifiable risk, or idiosyncratic risk)
Why Only Systematic Risk is Compensated:
- Diversification Principle: CAPM assumes investors hold well-diversified portfolios
- Elimination of Unsystematic Risk: Through diversification, unsystematic risk can be completely eliminated from a portfolio
- Market Efficiency: Only non-diversifiable risk should be priced by the market
Why Other Options Are Incorrect:
- Option B: Investors are NOT compensated for unsystematic risk since it can be diversified away
- Option C: CAPM specifically states compensation is only for systematic risk, not both
- Option D: Asset-specific risk is a type of unsystematic risk and therefore not compensated
The CAPM formula itself (E(Ri) = Rf + βi(E(Rm) - Rf)) reflects this principle, where beta (β) measures only systematic risk exposure.
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