IAI Actuarial Core Principles · Business Finance · Key principles of finance
Under the Capital Asset Pricing Model, which risk is rewarded with a higher expected return?
Systematic risk, measured by beta, is rewarded under CAPM. Specific risk can be removed by diversification, so investors holding diversified portfolios are not compensated for it. Total standard deviation includes diversifiable risk and so does not determine the required return.
- ATotal risk measured by the standard deviation of the security's returns
- BUnsystematic risk specific to the company
- CSystematic risk measured by betaCorrect
- DDefault risk of the company's own debt only
- Liquidity risk of the shares only
Explanation
CAPM assumes investors hold well-diversified portfolios, so unsystematic risk is diversified away and earns no premium. Only systematic (market) risk, measured by beta, is priced. Total risk is wrong because it includes the diversifiable part.
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