Frequently Asked Questions

Exercise set 5 (Q8)

The question asks to select the correct answer assuming a world where the CAPM conditions are verified. The correct answer is d) One stock with higher volatility might have lower expected return than another stock with lower volatility.

Investors can eliminate company-specific risk (Idiosyncratic risk) simply by properly diversifying portfolios, they are not compensated for bearing unsystematic risk. And because well-diversified investors are exposed only to systematic risk, with CAPM the relevant risk in the financial market’s risk/expected return tradeoff is systematic risk rather than total risk. Thus, an investor is rewarded with higher expected returns for bearing only market-related risk. Therefore, in d) stock A with higher volatility might have lower expected return than another stock B with lower volatility, if its systematic risk is lower than B's systematic risk (which implies that A has a higher idiosyncratic risk than B).