NAME: Devienna Antonetta Sudiarto

NIM: 201950456

Chapter 8: Risk and Return

The capital asset pricing model (CPAM) is the basic theory that links risk and
return for all assets. CPAM will be used to understand the basic risk-return trade-offs
involved in all types of financial decisions.
The standard deviation of a portfolio is often less than the standard deviation of the
individual assets in the portfolio. The types of risk are:
Total risk is the combination if a security’s non-diversifiable risk and diversifiable
risk. Non-diversifiable risk is the relevant portion of an asset’s risk attributable to
market factors that affect all firms; cannot be eliminated through diversification; is also
called systematic risk. Diversifiable risk is the portion of an asset’s risk that is
attributable to firm-specific, random causes; can be eliminated through diversification;
is also called unsystematic risk.
Formula: Total Security Risk = Non-diversifiable risk + Diversifiable risk
The CPAM links non-diversifiable risk to expected returns and the model can be
divided into 5 (five) sections:
1. Beta coefficient (β)
The beta coefficient (β) is a relative measure of non-diversifiable risk. It is an
index of the degree of movement of an asset’s return in response to a change in
the market return. A market return is the return on the market portfolio of all
traded securities.

2. Equation of the model

NAME: Devienna Antonetta Sudiarto
NIM: 201950456

The CPAM is divided into two parts: (1) the risk-free rate of return (RF) which
is the required return on a risk-free asset, typically a 3-moth U.S. Treasury bill
(T-bills) which are short-term IOUs issued by the U.S. Treasury; is considered the
risk-free asset.

3. Graphically describes the relationship between risk and return

The security market line (SML) is the depiction of the capital asset pricing
model (CPAM) as a graph that reflects the required return in the marketplace for
each level of non-diversifiable risk (beta/β).
4. Effects of changes in inflationary expectations and risk aversion on the
relationship between risk and return
The changes in inflationary expectations result in parallel shifts in the SMK in
direct response to the magnitude and direction of the change.
The slope of the SML reflects the degree of risk aversion, which means the
steeper its slope, the greater the degree of risk aversion because a higher level of
return will be required for each level of risk as measured by beta. In other words,
risk premiums increase with increasing risk avoidance.
5. Comments on the CPAM
The CPAM was developed to explain the behaviour of security prices and
provide a mechanism whereby investors could assess the impact of a proposed
security investment on their portfolio’s overall risk and return. It is based on an
assumed efficient market with the following characteristics:
 Many small investors, all having the same information and expectations
with respect to securities
 No restrictions on investment, no taxes, and no transaction costs
 Rational investors, who view securities similarly and are risk averse,
preferring higher returns and lower risk.
NAME: Devienna Antonetta Sudiarto
NIM: 201950456