Systematic Risk Nonsystematic Risk

Non-diversifiable Diversifiable

 Also known as market  Also known as unique, or

Diversifiable
There is a reward for bearing
risk.
There is not a reward for
bearing risk unnecessarily.
risk that affects the asset specific risk that affects
entire economy a particular risk or industry
 Risk factors that affect a  The risk that can be
large number of assets eliminated by combining
 Includes such things as assets into a portfolio
changes in GDP,  A market portfolio has
inflation, interest rates, ZERO nonsystematic risk
etc.  If we hold only one asset, or
 Only relevant risk that assets in the same industry,
will remain (any investor then we are exposing
or firm must be ourselves to risk that we
concerned solely or could diversify away
mostly with systematic
risk, because the
expected return on a
risky asset depends only
on that asset’s
systematic risk - since
unsystematic risk can be
diversified away)

Investors get return for bearing Nonsystematic risk does not

Returns systematic risk earn a return as it can be
diversified away.

Beta Coefficient (b)

 It is a relative measure of systematic/ nondiversifiable risk.
 An index of the degree of movement of an asset’s return in response to a change in the market
return.
 An asset’s historical returns are used in finding the asset’s beta coefficient.
 The beta coefficient for the entire market equals 1.0. All other betas are viewed in relation to
this value.
 The market return is the return on the market portfolio of all traded securities.

b=1 b<1 b>1

implies the asset has the implies the asset has less implies the asset has more
same systematic risk as the systematic risk than systematic risk than the
overall market the overall market overall market

Expected Returns Formulas

Expected Returns of an Asset: Portfolio Expected Returns:

n m
E ( R ) =∑ P i R i E ( R P )=∑ w j E ( R j )
i=1 j=1

n = number of outcomes considered weighted average of the returns on the individual

Pi = probability of occurrence for the ith outcome assets from which it is formed
Ri = return for the ith outcome
 Compute the portfolio return for each state:
RP = w1R1 + w2R2 + … + wmRm

Variance for Unequal Probabilities Formula:

n
2
σ 2=∑ P j [ Ri−E ( R ) ]
i=1

Standard Deviation Formula:

√ σ 2=σ

Capital Asset Pricing Model (CAPM) Formula

Using the beta coefficient to measure non diversifiable risk, the capital asset pricing model (CAPM) is
given in the following equation:

RF
Risk-free rate of return

Required return on a risk-free

asset, typically a 3-month Treasury
bill (i.e. short-term gov’t bonds)
r j=R F + [ b j ( r m −R F ) ]
* A risk free asset has zero
Rj = required return on an asset j systematic and zero
Rf = risk-free rate of return; commonly measured as the return on nonsystematic risk
a U.S. treasury bill * T bill: systematic and non
bj = beta coefficient or systematic/non-diversifiable risk for asset j systematic risk is zero (i.e.
rm = market return; return on the market portfolio of assets SDV=0);
Variance is zero
Other things being equal,
1. The higher the beta (systematic risk);
the higher the required return;
( r m −R F )
the greater the risk premium should be
2. The lower the beta; Risk Premium
the lower the required return;
the lower the risk premium should be Also called the market risk
premium because it represents
the premium that an investor
must receive for taking the
average amount of risk associated
with holding the market portfolio
of assets.

 The CAPM relies on historical data which means the betas may or may not actually reflect the
future variability of returns.
 Therefore, the required returns specified by the model should be used only as rough
approximations.
 The CAPM assumes markets are efficient.

Good morning everyone  To help is in deciding how to better arrange our groups, we made a
consolidated list of our groups. If you have additional or better suggestions, please feel free to make
corrections or leave notes in the google sheet. Thank you and hope you have a nice day.