Schweser claims that the CAPM assumes that all investors who take on risk hold the same risky asset portfolio. I thought the CAPM was used to analyze individual securities or portfolios not the market as a whole? Can someone clarify what this means?
I’d want to read exactly what is in Schweser, but I think that the idea they’re trying to convey is that CAPM assumes that the only risk priced into a security is market risk; i.e., the model ignores idiosynchratic (company-specific) risk. Therefore, it assumes that each investor holds a well-diversified (i.e., market) portfolio, so the only risk is market risk.
So the CAPM calculates the expected returns for certain assets, assuming all investors are holding the market portfolio, and that is why the CAPM only incorporates systematic risk?
CAPM considers two items in terms of risk. Risk free rate (US treasury notes) and the expected return on the market as a whole. Country risk premium could also be another type of added risk given you are dealing with international developing markets.
Followup question:
According to the CAPM, the market porfolio:
A. Includes all risky assets investd in equal amounts
B. Is exposed to both unsystematic and systematic risk
C. Is perfectly positively correlated with other portfolios in the CML
Not sure, why the answer would be B, considering the fact the CAPM only considers systematic risk when pricing the security.
I thought CAPM considered both systematic and unsystematic risk.
Systematic Risk- Risk free rate, expected market return
Unsystematic Risk - Beta of an individual security.
Edit- If someone could correct me if im wrong, it would be much appreciated. I too, am now confused after reviewing this post.
Beta shows the return based on systematic risk in CAPM while alpha represents the return based on unsystematic risk.
How is alpha represented in the CAPM equation?
Alpha is the so called “abnormal return” above and beyond the theoretical expected return predicted by a pricing model such as the CAPM.
That is, alpha = Actual return - Expected return (For example, as per CAPM)
In the CAPM framework , as noted by Magician before, the only risk priced into the expected return of the asset is market risk.
So say CAPM predicts an expected return of 7% for a security, but this security somehow has an actual return of 9%, there is something extra not captured in the basic CAPM that is driving this additional 2%.
As the CAPM already prices market risk, the risk that is driving this extra 2% must be idiosyncratic/firm specific/unsystematic risk.
Hence: alpha represents unsystematic /firm specific risk
beta represents systematic/market risk
The (nominal) risk free rate simply compensates the investor for forgoing current consumption / expected inflation
A - no reason at all to include all risky assets in equal amounts - > incorrect
C- no reason to have perfect postive correlation (+1) with other portfolios - > incorrect
B - To be honest I am not sure I fully understand what they mean here.
But could this be interpreted as, yes the market portfolios itself is comprised of a number of firms/industries and say if one of those industries has some regulatory changes (idiosyncratic risk in that it affects a selected few firms), given they are part of the market, the market portfolio is “exposed” to them ??