The Capital Asset Pricing Model
When making investment decisions, every investor has to account for the total risk to the investment. The total risk is an aggregate of both the systematic and unsystematic risks associated within an investment (asset portfolio). The systematic risks also called the non diversifiable risks or market risks are risks caused by factors that affect the price of virtually all securities. They are the risk inherent in the entire market and include; interest rates, recessions and wars that affect the entire market and cannot be avoided even with diversification. These risks affect the entire range of portfolio investments whereas the unsystematic ones affect specific group of securities (Tatum).
The unsystematic risks on the other hand are also called diversifiable or residual risks. They are unique and affect specific assets and include the losses caused by labor problems, the out comes of unfavorable litigation, natural catastrophes and the nationalization of assets. Besides being unique to a security, they often relate to unexpected piece of good news and bad news relating either o the company concerned or the industry in which it operates.
These risks can be reduced by diversifying the asset portfolio so that a single event affects only a limited number of the
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The three risks are so related in that the decomposition of total risks into diversifiable and non diversifiable emerged from the portfolio approach of capital investment now known as Capital Asset Price Model (CAPM) (Horim and Levy). But the question at hand is why are the non diversifiable risks regarded as the only relevant risks?
The non diversifiable risks are regarded as relevant risks since they relate with market forces. Much as they are beyond the control of the investors, this does not succeed them to be irrelevant. They are relevant because in the event of assessing the company’s portfolio, much concern is directed towards market effect on the business. Where the company is much sensitive to market forces, it is regarded to have high systematic risk.
To measure this risk, a beta rationale is used where a beta of 1.0 will indicate the firm reacts as the market does, a beta of more than 1.0 indicates a more sensitive company towards the market risks while a beta of less than 1.0 indicates a less sensitive company towards these market forces. They are also relevant because in one way or the other, any risk has to affect asset portfolio in any regard.
Much as the diversifiable and non diversifiable risks are defined as the contemporary components of the standard deviation of the security’s return, it appears that the decomposition of the total risk into systematic and unsystematic risks is vague and in most cases imprecise. This makes the non diversifiable risk to be relevant in that its measure will completely determine the equilibrium market price. The definition presented appeals for all the securities and particularly those with a negative beta as measured in the systematic risks.
In using the CAPM model to compute the systematic risks as the only relevant risks, an assumption of risk averse of an investor is considered. This is computed as risk free rate plus the differences between the market rate and the risk free rate multiplies by the company’s beta to ascertain the company’s cost of capital (Ross 1977). But as much the investors would wish to averse all the risks associated with the investment, it is not certain that all the known risks are eliminated?
In following up the portfolio theory, an elimination of unsystematic (diversifiable) risks creates an opportunity cost. In that by averaging this way, an investment will be conducted in a poorly managed company with the well run entities. This rationale puts off the diversifiable risks to be relevant leaving the non diversifiable ones to be relevant risks. Further, although the non diversifiable risks affect all the investment returns, some other assets are more sensitive to systematic risks than the others. For example, some stocks may have greater volatility due to systematic risk than the general market.
Therefore, it is prudent for an investor to demand a greater return from the stock than the market return. This makes the risk to be more relevant than the diversifiable risk. Finally, even though the systematic risk can be mitigated only by being hedged, it is clear that the even a well diversified portfolio cannot be protected against all risks. This makes the systematic risks to be so relevant risks in that they generally affect all the assets in a given portfolio.
The idea of portfolio theory concludes that it is always possible to diversify the unsystematic risks in investing in different entities that operate in different industries leaving only the systematic ones to relate with the market. Meaning that the return of the total portfolio can be achieved through aggregation systematic and unsystematic risks that form the total risks associated with a given investment.
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Ross, S.A., (1977), ‘The Capital Asset Pricing Model (CAPM), Short sale restrictions and related issues, Journal of finance, 32 (177)
Tatum M., ‘What is total risk’, Retrieved 21 July 2010 from http://www.wisegeek.com/what-is- total-risk.htm