In the context of the Capital Asset Pricing Model (CAPM), the relevant risk is

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BlackTom AI · Accepted Answer

We begin by restating the core question: In the context of the Capital Asset Pricing Model (CAPM), the relevant risk is what?

First, recall a key principle of CAPM: investors are compensated for bearing systematic (market) risk, which cannot be diversified away, while idiosyncratic (firm-specific) risk can be eliminated through diversification. This distinction underpins the idea that only certain risk factors matter for expected returns.

Next, consider the concept of market risk (also called systematic risk): it arises from broad economic factors that affect almost all assets, such as changes in interest rates, inflation, or market-wide beta movements. In CAPM, this risk is captured by the asset's beta, which measures sensitivity to the overall market. Because this risk is non-diversifiable, it directly influences the expected excess return demanded by investors.

Now, if we imagine typical answer options, the one reflecting this core idea would identify market risk (systematic risk) as the relevant risk in CAPM.

If an option suggested that only firm-specific risk mattered, that would be incorrect because diversifiable risk does not affect the market-wide required return once a portfolio is well diversified. If another option claimed that only total volatility or standard deviation matters without separating systematic from idiosyncratic components, that would be misleading in CAPM terms, since CAPM’s pricing hinges on beta, not total variance alone. If an option claimed that risk is unrelated to market movements or that all risks are equally priced, that would contradict the fundamental CAPM relationship between expected return and beta.

In summary, the framework hinges on distinguishing between market (systematic) risk, which is priced, and firm-specific (idiosyncratic) risk, which is not. The CAPM formulation implies that the relevant risk for expected return is the portion of risk that moves with the overall market, i.e., market risk.

Note: The provided options list is missing in this instance, so the analysis centers on the CAPM principles described above and how they identify market risk as the relevant risk for pricing assets.

FINS5513-Investments & Portfolio Sel. T1 2025

In the context of the Capital Asset Pricing Model (CAPM), the relevant risk is

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