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The investors can eliminate the unsystematic risk by holding a
diversified portfolio. However, the systematic risk cannot be eliminated
even if one holds virtually all stocks. The core idea of CAPM is that
only undiversifiable risk is relevant in the determination of expected
return on any asset. Since the diversifiable risk can be eliminated,
there is no reward for bearing it.
The systematic risk is measured by\u03b2 \u2212 the sensitivity of a security\u2019s
return to market return. These sensitivities differ from security to
security. There are some securities more volatile than the others.
CAPM states that differences in the expected return of any two assets
are because of differences in\u03b2 (market sensitivity). The securities with
higher (lower)\u03b2 will offer higher (lower) return.
So the CAPM delivers an expected value for securityi's excess return
that is linear in thebeta, which is security specific. Statistically,beta
can be interpreted as the individual security's contribution to the
variance of the entire portfolio. The security'srisk is referred to its
contribution to the variance of the portfolio's return -- not to the
This relation holds forall securities and portfolios. If we are given a
portfolio'sbeta and the expected excess return on the market, we can
calculate its expected return.
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