According to the CAPM, the expected return from a risky asset is a function of:

According to the CAPM, the expected return from a risky asset is a function of:
A . how much the risky asset contributes to portfolio risk
B . diversifiable risk that the asset brings
C . the riskiness, ie the volatility of the risky asset alone
D . all of the above

View Answer

Answer: A

Explanation:

According to the CAPM, the expected return from a risky asset is a function of the contribution of the risky asset to the total risk of the market portfolio. Nothing else matters. All assets are priced according to the risk they bring to the market portfolio, regardless of their individual level of risk. An asset that is very volatile on its own, but has a negative correlation to the market may be priced high, ie have low expected return, because of its impact on the risk of the market portfolio. Therefore Choice ‘a’ is the correct answer, and the other options are incorrect.

Recall that according to the CAPM = covariancex, y / variancex, where x is the market portfolio and y is the risky asset.

The beta itself is a function of the covariance of the asset’s returns with market returns, and therefore only the driver of expected return for an asset is its beta, which is determined by the asset’s contribution to portfolio risk. ( = covariance(x, y) / variance(x), where x is the market portfolio and y is the risky asset. )