Question
According to the Capital Asset Pricing Model (CAPM), the
relevant risk of a security is its:Solution
- The CAPM is a cornerstone of modern portfolio theory. It makes a crucial distinction:
- Total Risk (measured by variance or standard deviation) includes both systematic and unsystematic risk.
- Unsystematic (Firm-specific) Risk: Risk unique to a company (e.g., management quality, product failure). This risk can be diversified away by holding a large portfolio.
- Systematic (Market) Risk: Risk that affects the entire market (e.g., interest rate changes, recessions, wars). It cannot be diversified away .
CAPM posits that in an efficient market, investors are only rewarded for bearing non-diversifiable systematic risk . This risk is measured by Beta ( β ) , which quantifies a security's sensitivity to movements in the overall market.
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