Asset Pricing Model – Risk and Return CAPM and Cost of Capital Flashcards
Systematic Risk
is any risk that affects a large number of assets, each to a greater or lesser degree.
Uncertainty about general economic conditions, such as GNP, interest rates, or inflation, are examples of systematic risk. These conditions affect nearly all stocks to some degree. An unanticipated or surprise increase in inflation affects wages and the costs of the supplies that companies buy, the value of the assets that companies own, and the prices at which companies sell their products. These forces to which all companies are susceptible are the essence of systematic risk. The “COVID crash” in the spring of 2020 is a particularly recent and vivid example of such a risk.
Unsystematic Risk
An unsystematic risk is a risk that specifically affects a single asset or a small group of assets. It is the risk that is not related to the overall market movements and can be attributed to factors unique to a specific business or sector. Unsystematic risk can be minimized by building a diversified portfolio of investments.
example - Market Risk: Market risk can affect specific industries or sectors due to changes in demand, supply, or pricing dynamics. For example, the demand for oil companies’ products can be influenced by geopolitical events and global economic conditions
Beta Risk
In the financial markets the risk that matters is the degree to which a particular share tends to move when the market as a whole moves. This is the only issue of concern to investors that are fully diversified, because ups and downs due to specific company events do not affect the return on the portfolio – only market-wide events affect the portfolio’s return. This is leading to a new way of measuring risk. For the diversified investor, the relevant measure of risk is no longer standard deviation, it is systematic risk. The Capital Asset Pricing Model defined this systematic risk as beta. 7 Beta ( B ) measures the covariance between the returns on a particular share with the returns on the market as a whole In the CAPM model, because all investors are assumed to hold the market portfolio, an individual asset (e.g. a share) owned by an investor will have a risk that is defined as the amount of risk that it adds to the market portfolio. Assets that tend to move a lot when the market portfolio moves will be more risky to the fully diversified investor than those assets that move a little when the market portfolio moves. To the extent that asset movements are unrelated to the market portfolio’s movement they can be ignored by the investor because, with full diversification, this unsystematic risk element will be eliminated when the asset is added to the portfolio. Therefore only co-movements with the market portfolio count.
