According to CAPM, what does a stock's beta measure?
AThe stock's total return volatility (standard deviation)
BThe stock's expected return above the risk-free rate
CThe stock's sensitivity to market-wide movements — its systematic risk relative to the market
DThe stock's idiosyncratic risk that can be eliminated through diversification
Beta measures how much the stock moves with the market — technically, it is the covariance of the stock's returns with the market's returns divided by the variance of the market. A beta of 1.5 means the stock tends to move 1.5% for every 1% market move. Total volatility (standard deviation) includes both systematic and idiosyncratic risk; CAPM says only the systematic component (beta) is priced because idiosyncratic risk can be diversified away.
Question 2 True / False
According to CAPM, a fully diversified investor should demand compensation for most risk in a stock, including company-specific (idiosyncratic) risk.
TTrue
FFalse
Answer: False
This is the central insight of CAPM: idiosyncratic risk — risk unique to a single company, like a CEO departure or a product recall — can be eliminated by holding a diversified portfolio. Rational investors will not pay a premium to avoid risk they can diversify away for free. Therefore, the market only compensates for systematic risk (beta), which cannot be eliminated through diversification because it comes from economy-wide factors.
Question 3 Short Answer
What does it mean for a stock to plot above the Security Market Line (SML), and what would a CAPM investor do?
Think about your answer, then reveal below.
Model answer: A stock above the SML offers a higher expected return than CAPM predicts for its level of beta — it is underpriced (alpha is positive). A CAPM investor would buy it, since it delivers more return per unit of systematic risk than equilibrium requires.
The SML maps every level of beta to the return that exactly compensates for systematic risk. Points above the line have positive alpha — they are delivering excess return for their risk. In a CAPM world, investors would rush to buy such stocks, bidding up the price and driving the expected return down until the stock sits back on the SML. Points below the line are overpriced and would be sold. In equilibrium, all assets lie exactly on the SML.