How are total risk nondiversifiable risk and diversifiable r

How are total risk, nondiversifiable risk, and diversifiable risk related? Why is nondiversifiable risk the only relevant risk? Explain the meaning of each variable in the CAPM equation. Reply

Solution

The Capital Asset Pricing Model (CAPM) is an equilibrium model of asset prices in a risky market.

The Central theme of the Capital Asset Pricing Model (CAPM) states that Risk can be decomposed into Systematic and Unsystematic Risk. Unsystematic risk is diversifiable so the only relevant risk is the Systematic Risk or Non diversifiable risk and it is captured by Beta.

Total Risk can be defined as Systematic Risk plus Unsystematic Risk.

Unsystematic risk or Diversifiable Risk : This risk can be avoided through diversification. The greater the number of stocks in our portfolio, the greater will be the chance of Unsystematic risk to be cancelled out. This type of risk is unique to a particular company or industry. This is the risk of price change due to unique circumstances of a specific security as opposed to the overall market. This risk can be virtually eliminated through diversification.

Systematic risk or Non diversifiable risk : This risk cannot be avoided through diversification as it is inherent risk to the market. These risks arise to factors that affect the overall market such as changes in the national economy, tax reform by government etc. This is the risk which is common to an entire class of assets or liabilities. These risks cannot be diversified as it affects the securities overall.

Since Cash flows are risky the required rate of return is Risk Adjusted Return.

As per the assumptions of CAPM, the only relevant measure of risk is Systematic or Non Diversifiable risk. The Systematic Risk of a stock refers to sensitivity of the stock to the economy. Economy is captured by Market Portfolio and Systematic risk is measured in terms of Beta i.e. Sensitivity with respect to market. As stated above Systematic risk cannot be avoided through diversification as it is inherent risk to the market. However Unsystematic risk can be avoided through diversification. Therefore it can be concluded that Non Diversifiable risk is the only relevant risk.