Question

Do investors require a premium for holding idiosyncratic risk? Do investors require a premium for holding systematic risk? Explain your answers for full credit, giving economic intuition for the reason.

Answer 1

We know that systematic risk are the risks which arises because of economy wide factors such as GDP growth rate, interest rate and oil prices etc, whereas idiosyncratic risk are the risk which arises on account of internal factors specific to the company. Since all investors invest in the market portfolio (i.e. diversified portfolio), idiosyncratic risk is gone. Investors require compensation only for the systematic risk. Further the quantity of systematic risk of a stock is represented by beta of that stock (i.e. sensitivity of stock return to market return).

Therefore, investor doesnot require a premium for holding idiosyncratic risk as it is gone by diversification. Investors only require premium for holding systematic risk (and the same is captured in the CAPM formula as well i.e Risk free rate plus systematic risk premium required i.e. (Rm-Rf)*Beta).