Question

discuss the concept of risk and diversification in relation to the capital asset pricing model (500 words)

Answer 1

The Concept of Risk and Diversification in relation to the Capital Asset Pricing Model

Capital Asset Pricing Model helps to calculate the return anticipated by the investor at a given level of risk of the investment. CAPM measures the sensitivity of asset's return with respect to the risk level of the investment. This model states that the total risk of an investment is made up of Systematic (non diversifiable) risk and Unsystematic (diversifiable) risk.

Risk

Risk is the amount of loss because of the variability in returns. According to CAPM, there are two types of risks.

1. Systematic risk : These risks are uncontrollable and non diversifiable in nature. These are market risk which is associated with the market as a whole.
2. Unsystematic risk : These are controllable and diversifiable risks because these are investment specific risk. It is unique to a firm.

Diversification

It is the process of investing the money in different classes of assets so that the risk can be minimised. The investors always wish to diversify the portfolio until they are efficient. As per CAPM since the investors diversify their portfolio, they are exposed only to systematic risk. Then the investors will get higher return only for suffering systematic risk. Investors need not worry about unsystematic risk since it is diversifiable.