Financial Risk Manager Part 1

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:

1. Diversification Principle: CAPM assumes investors hold well-diversified portfolios
2. Elimination of Unsystematic Risk: Through diversification, unsystematic risk can be completely eliminated from a portfolio
3. 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.