Question

Both Beta in the CAPM and the standard deviation measure the risk of any asset. Which of these measures best captures the risk of an asset when we think about the return we expect from that asset? Explain.

Answer 1

Beta captures the risk of an asset when we think about the return we expect from that asset. We know that standard deviation captures total risk which consists of idiosyncratic (or unique or firm-specific or non systematic risk ) and market risk (or systematic risk). However beta captures only market risk. Additionally, non systematic risk can be diversififed away by randomly adding stocks in the portfolio which have less than perfect positive correlation. Hence, investors wont be compensated for non systematic risk as it can be diversified free of cost. But systematic risk cannot be diversified away. Therefore, investors will be compensated for only market risk or systematic risk. Hence, the risk measure which determines the return is beta.