Practice Quiz

FRM Financial Risk Manager Practice Test

Category - The Capital Asset Pricing Model

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The CAPM decomposes a portfolio’s risk into systematic risk and specific risk. However the CAPM model only compensates investors for taking systematic risk, not specific risk. Why is this the case?
  1. Because the CAPM favors systematic risk.
  2. Because systematic is diversifiable, while specific risk is undiversifiable.
  3. Because systematic is undiversifiable, while specific risk is diversifiable.
  4. Because investors only accept systematic risk, not specific risk.
Explanation
Systematic is undiversifiable, while specific risk is diversifiable. Investors are exposed to both risks but since specific risk is diversified away, the investors’ net exposure is just systematic risk.

Key Takeaway: The CAPM formula is: Expected Return = Risk free rate + beta*(Market return -risk-free rate). Systematic risk can be measured using beta. Given a beta and an expected return for an asset, investors will bid its current price up or down, adjusting that expected return so that it satisfies the CAPM formula.
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