Question

The CAPM excludes a term called alpha because:

a	We assume that investors will not want this excess return.

b	We assume that the diversifiable risk (a/k/a idiosyncratic risk) which is denoted by the term "α", can be eliminated through proper portfolio management techniques.

c	Over the long run this term trends to zero therefore it is excluded in cost of capital calculations.

d	We assume investors are only rewarded for risk they actually take; irrespective of the returns of other similar securities.

Answer 1

ANSWER

CORRECT OPTION : Option (b) : We assume that the diversifiable risk (a/k/a idiosyncratic risk) which is denoted by the term "α", can be eliminated through proper portfolio management techniques

EXPLANATION

• Capital Asset Pricing Model excludes the "Diversifiable Risk" while calculation of Required Return due to the reason that such risk is not Market Specific. Such Risk is "Stock Specific" and hence can be eliminated by proper portfolio management techniques.
• Such diversifiable risk is denoted by term alpha
• CAPM only considers the "Market Risk" which will be present in each and every stock in the Market and therefore it can't be eliminated by diversification of portfolio.