Capital asset pricing theory asserts that portfolio returns are best explained by ________ risk.
Systemic risk
Capital Asset Pricing Theory (CAPM) asserts that portfolio returns are best explained by systematic risk.
However, to understand how CAPM arrived at this assertion, let me break it down for you:
1. Start with the concept of risk: Risk in investing refers to the uncertainty or variability of returns. It is crucial to analyze and understand the risks associated with an investment as it directly affects the potential return.
2. Distinguish between two types of risk: In finance, there are two types of risk: systematic risk and unsystematic risk.
a. Systematic risk (also known as market risk) is non-diversifiable or market-wide risk that affects the overall market or a specific industry. It includes factors such as interest rate movements, inflation, and economic conditions. Investors cannot eliminate systematic risk through diversification since it is inherent in the market itself.
b. Unsystematic risk (also known as specific risk) is individual or company-specific risk that can be reduced through diversification. Examples include labor strikes, management changes, and company-specific factors.
3. Define the Capital Asset Pricing Model (CAPM): CAPM is a financial model that quantifies the relationship between the expected return of an asset or a portfolio and its systematic risk. It provides a framework for pricing risky assets and determining the appropriate required rate of return.
4. Key assumptions of CAPM: The model is based on some key assumptions:
a. Investors are rational and risk-averse.
b. There is a risk-free rate of return.
c. All investors have access to the same information and agree on the future expectations of asset returns.
d. Investors can lend or borrow at the risk-free rate.
e. There are no transaction costs or taxes.
f. All investors have homogeneous expectations about future returns.
5. Explaining portfolio returns with systematic risk: CAPM asserts that the expected return of a portfolio (or an individual asset) is determined by its exposure to systematic risk, represented by the beta coefficient. The beta measures the sensitivity of an asset's returns to market movements. A beta greater than 1 implies higher market sensitivity, while a beta less than 1 indicates lower sensitivity.
6. The equation of CAPM: According to CAPM, the expected return of a portfolio is equal to the risk-free rate plus the market risk premium multiplied by the portfolio's beta. The formula is as follows:
E(Rp) = Rf + βp * (Rm - Rf)
E(Rp) = Expected return of the portfolio
Rf = Risk-free rate of return
βp = Beta of the portfolio
Rm = Expected return of the market
(Rm - Rf) = Market risk premium
By incorporating systematic risk through beta, CAPM provides a way to estimate the expected return of a portfolio based on its risk level, as measured by market sensitivity.
In summary, CAPM asserts that portfolio returns are best explained by systematic risk, as it is the primary driver of returns that cannot be diversified away.