FRM Part II · FRM Exam Part II · Factors
Which statement about the CAPM's treatment of risk is correct?
Only systematic risk is priced in the CAPM. Investors can diversify away idiosyncratic risk at no cost, so it earns no premium. Expected return depends on beta, which measures sensitivity to the market portfolio, not on total volatility.
- AOnly systematic risk is priced because idiosyncratic risk can be diversified awayCorrect
- BTotal volatility determines expected return for every asset
- CIdiosyncratic risk earns a premium proportional to its variance
- DBeta measures an asset's total risk relative to the risk-free asset
Explanation
In the CAPM, investors hold diversified portfolios, so idiosyncratic risk is not compensated. Expected return depends on beta, the covariance with the market scaled by market variance. Total volatility includes diversifiable risk, so it does not set the premium.
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