Systematic and Unsystematic Risk and Capital Asset Pricing Model (CAPM)

The Concept of the CAPM

The Capital Asset Pricing Model (CAPM) is a financial model that establishes a linear relationship between the expected return of an asset and its systematic risk (market risk). It is used to price risky securities and determine the required rate of return on an investment, given its risk relative to the overall market.

The core idea is that investors must be compensated in two ways:

Time value of money (the risk-free rate, $R_{f}$ Rf)
Risk premium for taking on extra risk (the asset’s sensitivity to market movements, multiplied by the market risk premium).

The CAPM formula is:

E (R_{i}) = R_{f} + β_{i} \times (E (R_{m}) - R_{f})

Where:

$E (R_{i})$ = expected return on asset $i$
$R_{f}$ = risk-free rate (e.g., government bond yield)
$β_{i}$ = beta of asset $i$ i (measures sensitivity to market returns)
$E (R_{m})$ = expected return of the market portfolio
$E (R_{m}) - R_{f}$ = market risk premium

Beta (β) is the key measure:

$β = 1$ : asset moves with the market
$β > 1$ : asset is more volatile than the market
$β < 1$ : asset is less volatile than the market

CAPM Model, Systematic ও Unsystematic Risk | সহজ বাংলায় সম্পূর্ণ Video Tutorial

Capital Asset Pricing Model (CAPM) আধুনিক ফাইন্যান্স ও বিনিয়োগ ব্যবস্থাপনার অন্যতম গুরুত্বপূর্ণ মডেল, যা ঝুঁকি (Risk) এবং প্রত্যাশিত আয় (Expected Return)-এর মধ্যে সম্পর্ক ব্যাখ্যা করে। এই ভিডিওতে CAPM Model, Systematic Risk (বাজার ঝুঁকি), Unsystematic Risk (প্রতিষ্ঠানভিত্তিক ঝুঁকি), Beta (β), Security Market Line (SML) এবং Portfolio Diversification অত্যন্ত সহজ বাংলায় বাস্তব উদাহরণের মাধ্যমে ব্যাখ্যা করা হয়েছে। পাশাপাশি কেন Systematic Risk বৈচিত্র্যকরণের (Diversification) মাধ্যমে দূর করা যায় না, কিন্তু Unsystematic Risk একটি সুষম পোর্টফোলিও গঠন করে অনেকাংশে কমিয়ে আনা সম্ভব—তা ধাপে ধাপে আলোচনা করা হয়েছে। এছাড়াও CAPM ব্যবহার করে কীভাবে Cost of Equity, Required Rate of Return এবং বিনিয়োগের যৌক্তিকতা মূল্যায়ন করা হয়, সেটিও বিস্তারিতভাবে তুলে ধরা হয়েছে।

আপনি যদি CAPM Model, Capital Asset Pricing Model, Systematic Risk, Unsystematic Risk, Beta (β), Security Market Line (SML), Expected Return, Cost of Equity, Portfolio Management, Fundamental Analysis অথবা শেয়ার বাজারে ঝুঁকি ও রিটার্ন বিশ্লেষণ সহজভাবে শিখতে চান, তাহলে নিচের Play বাটনে ক্লিক করে সম্পূর্ণ ভিডিওটি দেখুন। এই ভিডিওটি Finance & Banking, BBA, MBA, CFA, FRM, বিশ্ববিদ্যালয় ভর্তি পরীক্ষার্থী এবং শেয়ার বাজারে আগ্রহী বিনিয়োগকারী—সবার জন্য সমানভাবে উপযোগী। ভিডিওটি শেষ করার পর নিচের লেকচার নোট ও কুইজের মাধ্যমে নিজের প্রস্তুতি আরও শক্তিশালী করে তুলুন।

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CAMP · Risk‑Return Graph

Market (M) Security (S) Efficient Frontier Risk‑free (R_f)

β (Beta) 1.30 MRP (E[R_m] – R_f) 7.5%

E[R_i] = R_f + β · (E[R_m] – R_f) · Risk = β · σ_m · σ_m = 16% · R_f = 2.5%

📊 Beta

Measures systematic risk relative to the market.

📈 MRP

Market Risk Premium – expected excess return.

🎯 SML

Security Market Line shows fair expected return.

Main Assumptions of the CAPM

The model rests on several strong assumptions about markets and investor behavior:

Assumption	Description
Rational investors	Investors are risk-averse and seek to maximize expected utility of end-of-period wealth.
Single-period horizon	All investors have the same holding period (typically one year).
No taxes or transaction costs	Trading is frictionless; no costs, taxes, or restrictions on short-selling.
Perfectly divisible assets	Investors can buy or sell any fraction of any asset.
Homogeneous expectations	All investors have identical views on expected returns, variances, and correlations of all assets.
Risk-free asset exists	Investors can borrow and lend unlimited amounts at the risk-free rate.
Market portfolio is efficient	All investors hold the same tangency portfolio (the market portfolio), which contains all risky assets in proportion to their market value.
No inflation or interest rate changes	The model ignores changes in purchasing power and interest rates over the period.
All information is freely available	Markets are informationally efficient; all relevant information is reflected in prices instantly.

Limitations of the CAPM

Despite its widespread use, the CAPM has significant practical and theoretical shortcomings:

Limitation	Explanation
Unrealistic assumptions	Frictionless markets, homogeneous expectations, and unlimited borrowing/lending at the risk-free rate do not hold in reality.
Single-factor reliance	Only market risk (beta) explains returns, ignoring other risk factors like size, value, momentum, or profitability (which are captured by multi-factor models like Fama-French).
Market portfolio is unobservable	The “true” market portfolio should include all investable assets (stocks, bonds, real estate, human capital, etc.), but proxies (e.g., S&P 500) are incomplete.
Beta instability	Beta is estimated from historical data and is not stable over time, making forward-looking predictions unreliable.
Poor empirical performance	Empirical studies (e.g., Fama & French, 1992) show that beta alone does not fully explain average stock returns; low-beta stocks often outperform high-beta stocks relative to CAPM predictions.
Risk-free rate proxy issues	In practice, there is no truly risk-free asset, especially over long horizons; government bonds still carry inflation and interest rate risk.
No consideration of skewness or kurtosis	The CAPM assumes returns are normally distributed, ignoring tail risks, skewness, and extreme events (which matter to investors).
Assumes linear relationship	The model assumes a strictly linear risk-return trade-off, but in reality, the relationship may be non-linear, especially during market crashes.

Systematic Risk (Market Risk / Non-Diversifiable Risk)

Definition:
Systematic risk is the inherent risk that affects the entire market or a broad segment of the market. It stems from macroeconomic factors that impact all securities simultaneously, regardless of a specific company’s performance.

Key Characteristics:

Cannot be eliminated through diversification (you cannot avoid a market-wide recession by buying more stocks).
It is the only risk that is rewarded with a risk premium in the CAPM (this is what the beta coefficient measures).
It is external to the individual company.

Common Sources (Drivers):

Inflation and interest rate changes
Recessions or economic downturns
Political instability, wars, or geopolitical events
Natural disasters (on a massive scale)
Currency fluctuations and global trade policies

Unsystematic Risk (Specific Risk / Diversifiable Risk / Idiosyncratic Risk)

Definition:
Unsystematic risk is the risk that is specific to a particular company, industry, or sector. It arises from events that are unique to that individual entity and does not affect the broader market as a whole.

Key Characteristics:

Can be reduced or eliminated through diversification (holding a well-balanced portfolio of different stocks and sectors cancels out company-specific bad news).
It is not rewarded with a risk premium in the CAPM because investors can avoid it at no cost by diversifying.
It is internal or industry-specific to the company.

Common Sources (Drivers):

Poor management decisions or leadership scandals
Product recalls or failed product launches
Labour strikes or supply chain disruptions (localized)
Loss of a major client or patent expiry
Industry-specific regulatory changes (e.g., new drug approval rules for pharma)

How They Relate to the CAPM

The CAPM is built on the idea that rational investors will diversify away all unsystematic risk for free. Therefore, the market will only compensate investors for bearing systematic risk, which cannot be avoided.

In the CAPM formula:

The beta (β) captures only the asset’s exposure to systematic risk relative to the market.
The unsystematic risk is completely ignored in the formula, because the model assumes it is diversified away in a well-constructed portfolio.

In short:
Systematic risk = unavoidable, market-wide → rewarded (captured by beta).
Unsystematic risk = company-specific, avoidable → not rewarded (diversified away).

Summary

The CAPM is a foundational tool in finance for estimating the cost of equity and evaluating portfolio performance. However, its simplicity comes at the cost of realism, and practitioners often supplement it with multi-factor models (e.g., Fama-French 3-factor or 5-factor) or use conditional CAPM variants that allow betas and risk premia to change over time. While the CAPM is still widely taught and used as a benchmark, its limitations mean it should be applied with caution and adjusted for context.