Question

“The variance (total risk) of an asset can be decomposed into market risk component and firm-specific risk component. The market risk is the relevant risk because it cannot be eliminated by constructing a well-diversified portfolio.” True or false?

Answer 1

The Correct answer is True.

The Capital Asset Pricing Model (CAPM) is an equilibrium model of asset prices in a risky market.

The central theme of the Capital Asset Pricing Model (CAPM) states that Risk can be decomposed into Systematic or Market Risk and Unsystematic or Firm Specific Risk.

Unsystematic risk is diversifiable so the only relevant risk is the Systematic Risk captured by Beta.

Total Risk can be defined as Systematic Risk plus Unsystematic Risk.

Unsystematic or Firm Specific Risk: This risk can be avoided through diversification. The greater the number of stocks in our portfolio, the greater will be the chance of Unsystematic risk to be cancelled out. This type of risk is unique to a particular company or industry. This is the risk of price change due to unique circumstances of a specific security as opposed to the overall market. This risk can be virtually eliminated through diversification.

Systematic risk or Market Risk : This risk cannot be avoided through diversification as it is inherent risk to the market. These risks arise to factors that affect the overall market such as changes in the national economy, tax reform by government etc. This is the risk which is common to an entire class of assets or liabilities. These risks cannot be diversified as it affects the securities overall.

As per the assumptions of CAPM, the only relevant measure of risk is Systematic or Market Risk, The Systematic Risk of a stock refers to sensitivity of the stock to the economy. Economy is captured by Market Portfolio and Systematic risk is measured in terms of Beta i.e. Sensitivity with respect to market.

Therefore it can be concluded that Systematic or Market risk is the relevant risk which cannot be eliminated by constructing a well-diversified portfolio.