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FRM Part II · FRM Exam Part II · Factors

A risk analyst reviews a single-factor CAPM framework in which the only systematic risk factor is the market portfolio. Which statement best describes how an asset's expected excess return is determined in this framework?

In the CAPM an asset's expected excess return equals its beta times the expected market excess return. Only systematic risk, which cannot be diversified away, earns a risk premium, while idiosyncratic risk is not compensated.

  1. AIt equals the asset's own total volatility multiplied by the market Sharpe ratio plus its idiosyncratic variance
  2. BIt equals the asset's beta multiplied by the expected market excess return, because only systematic risk is rewardedCorrect
  3. CIt equals the asset's alpha plus the risk-free rate, because idiosyncratic risk is rewarded
  4. DIt equals the average historical return of the asset over the sample period, regardless of its beta

Explanation

Under the CAPM, expected excess return is beta times the market risk premium. Only non-diversifiable (systematic) risk earns a premium. Total volatility and idiosyncratic risk are diversifiable and are not priced, so the first and third options are wrong.

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