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According to CAPM, would investors be rewarded when they endure firm-specific risk? Why or why not?...

According to CAPM, would investors be rewarded when they endure firm-specific risk? Why or why not?

True/False: when 2 stocks have the same beta value, they have the same expected return and therefore possess the same level of risk.

Please answer the above questions in 3-5 sentences.

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Answer #1

As per CAPM, the systematic risk is measured based on the Beta value. Beta value or systematic risk is the risk associated with the market and not firm specific. CAPM rewards only systematic risk and no firm-specific risks. Further, it states that the firm specific risk can be diversified by investing in another company of the same industry, which doesn't have that specific risk. If the risk can be diversified by investors action, CAPM doesn't reward for taking such unnecessary risk.

False : Beta signifies only systematic risk, whereas the overall risk, denoted by standard deviation, is not embedded in beta. Thus, firms with same beta can have separate firm-specific risks and therefore the overall level of risk for them will not be the same. Refer above explanation for Question 1 on why Beta captures and rewards only systematic risk.

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