FRM Part II · FRM Exam Part II · Factors
An analyst notes that, under the CAPM, the expected return on any asset depends on only one source of systematic risk. Which statement best describes the risk the CAPM says is rewarded with a risk premium?
The CAPM rewards only systematic risk, measured by an asset's beta to the market portfolio. Idiosyncratic risk can be diversified away at no cost, so investors receive no premium for bearing it, and total volatility therefore does not determine expected return.
- ATotal volatility of the asset's returns
- BIdiosyncratic risk specific to the issuing firm
- CExposure to the market portfolio, measured by betaCorrect
- DSkewness of the asset's return distribution
Explanation
In the CAPM, investors hold diversified portfolios, so idiosyncratic risk is diversified away and unrewarded. Only covariance with the market portfolio, captured by beta, earns a premium. Total volatility includes diversifiable risk and so is not priced.
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