Chapter 13

1. According to CAPM, the expected return on a risky asset depends on three components.
Describe each component and explain its role in determining expected return.

CAPM suggests the expected return is a function of (1) the risk-free rate of return, which is the
pure time value of money, (2) the market risk premium, which is the reward for bearing
systematic risk, and (3) beta, which is the amount of systematic risk present in a particular asset.

2. Explain how the slope of the security market line is determined and why every stock that is
correctly priced, according to CAPM, will lie on this line.

The market risk premium is the slope of the security market line. Slope is the rise over the run,
which in this case is the difference between the market return and the risk-free rate divided by a
beta of 1.0 minus a beta of zero. If a stock is correctly priced the reward-to-risk ratio will be
constant and equal to the slope of the security market line. Thus, every stock that is correctly
priced will lie on the security market line

3. Explain the difference between systematic and unsystematic risk. Also explain why one of these
types of risks is rewarded with a risk premium while the other type is not.

Unsystematic, or diversifiable, risk affects a limited number of securities and can be eliminated
by investing in securities from various industries and geographic regions. Unsystematic risk is
not rewarded since it can be eliminated by investors. Systematic risk is risk which affects most,
or all, securities and cannot be diversified away. Since systematic risk must be accepted by
investors it is rewarded with a risk premium and is measured by beta.