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

Beta is the systematic risk or the undiversifiable risk of a security. It is also called 'Market Risk' as this is the risk inherent to the entire market. It affects the overall market, and not a particular stoc or security or industry. This risk cannot be completely removed using diversification. It can only be hedged. It is a largely unpredictable risk for example the current coronavirus pandemic is a systemic risk that is affecting all securities throughout the world.Systematic risk, incorporates interest rate changes, inflation, recessions, and wars, among other major changes. Shifts in these domains can affect the entire market and cannot be mitigated by changing positions within a portfolio of public equities.

These are the reasons why systematic risk is most important to think about, because it is the most difficult to mitigate.

I agree with the CAPM view on risk because:

1. All diversiafiable risks can be mitigated by planning the portfolio well and investing in various offsetting industries and asset classes. Hence CAPM considers only systematic risk, reflecting a reality in which most investors have diversified portfolios from which unsystematic risk has been essentially eliminated.

2. It is a theoretically-derived relationship between required return and systematic risk which has been subject to frequent empirical research and testing.