Question

According to the capital asset pricing model (CAPM) the only risk that matters is “market risk”, captured by beta (β). What type of risk is this and what does it entail? Why are all other types of risk less important? Do you agree with the CAPM view on risk or not?

Answer 1

According to the Capital Asset pricing model, investors who are invested into the market are already completely diversified so they are eliminating all kind of unsystematic risk in the portfolio and they will only be left with the systematic risk in the portfolio which is also known as market risk.

Market risk is risk related to all such market factors arising out of macro risk like inflation and interest rates which are beyond the control of country and It is not limited to industry-specific so this will be reflecting all the operation of the company and hence market risk will be impacting the overall rate of return of a security according to the Capital Asset pricing model and it will be reflected through beta as systematic risk.

All the other type of risk are also important because the investor is not completely diversified in the market and he will always be having unsystematic risk as well in his portfolio and it can be said that Capital Asset pricing model is not completely based upon real life theories and it is also not factoring all the risk associated with the performance of the portfolio and hence they will not be providing with the best estimate of expected rate of return and one should be trying to use arbitrage pricing theory for better adjustment of risk.