Capm Risk Case

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 = asset's variance

~ = asset's beta

cr m 2 = variance of the market

cr e 2 = asset's 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 investor's domestic

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