Essay About Risk Of An Individual Asset And Capm World

Capm Risk Case
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the risk of an individual asset into its market (or systematic) risk and its firm-specific (or
residua() risk with the following equation:
whetc:
cr2 = assets variance
~ = assets beta
cr m 2 = variance of the market
cr e 2 = assets residual risk
Because residual risk is uncorrelated with the market return, we can diversify away
the residual risk in a portfolio. Hence, for a well-diversified portfolio, the risk of the
portfolio is equal to:
This implies that the only risk that matters (in a CAPM world) is market risk.
LOS 62.c: Explain the assumptions of the domestic capital asset pricing model
(CAPM).
CPA® Program Curriculum, Volume 6, page 484
The following assumptions are necessary to derive the domestic CAPM:
Investors are risk-averse: They prefer more expected return and less risk (as measured
by variance), all else equal.
Investors have homogeneous expectations: They all have the same forecast of
expected returns, variances, and correlations.
Investors are concerned with nominal returns in their home currency (e.g., Canadian
investors are concerned with Canadian dollar returns).
There is a risk~free security available, and all investors can borrow and lend
unlimited amounts at the risk~free rate.
There are no taxes or transaction costs.
LOS 62.d: Justify extension of the domestic CAPM to an international
context (extended CAPM), and describe the assumptions needed to make the
extension.
CPA® Program Curriculum, Volume 6, page 488
The domestic CAPM has been extended to the international environment in a modd
called the extended CAPM. The justification for the extended CAPM is to provide a
common risk pricing framework that corresponds to the domestic CAPM [i.e., E(R) = Rr
+ (~ x MRP)]. In the extended CAPM, the risk-free rate (Rrl is the investors domestic