A treasurer holds a 1.4-beta stock and watches Treasuries rise 150 bps. The discount rate jumps, the required return climbs, and the price drops before earnings change at all. Risk-return is that mechanical.
Three returns matter. Realized return is what actually happened: (Ending value − Beginning value + Income)/Beginning value. Expected return is the probability-weighted forecast across scenarios. Required return is the minimum return that compensates for risk, set by the market and produced by CAPM.
For multi-period series, arithmetic mean overstates compound performance. Use the geometric mean when the question asks for actual growth over time: . Real return strips inflation: (1 + nominal) = (1 + real)(1 + inflation).
Systematic (market) risk comes from macro forces every firm faces: interest rates, recession, inflation shocks, geopolitics. It cannot be diversified away. Unsystematic (company) risk is firm-specific: a strike, product recall, CFO resignation, patent loss. Hold enough names and these wash out.
KEY: Markets reward you for bearing systematic risk only. Unsystematic risk is unpaid because it disappears with diversification.
Common mistakes
- Treating total risk as priced. CAPM rewards systematic risk only. Using total σ instead of β to compute required return is wrong.
- Averaging standard deviations. Portfolio σ is not . You must include the covariance term; when , the true σ is lower.
- Forgetting that beta change moves price inversely. Beta up means required return up means price down, not up. Candidates flip the sign because higher return sounds bullish.
Bottom line
- Total risk = systematic + unsystematic. Only systematic (market) risk is priced because firm-specific risk diversifies away.
- CAPM: Expected return = R_f + β(R_m − R_f); the bracket is the market risk premium and market beta is 1.0 by definition.
- Realized, expected, and required return are distinct; CAPM yields the required return used as a hurdle rate or SML benchmark.
- Four named risks: credit, foreign exchange, interest rate, and market, each mapping to a specific cash-flow or valuation channel.
Exam shortcut
When the question gives β, R_f, and R_m and asks for required return or cost of equity, plug into CAPM directly. Subtract R_f from R_m first; the bracket is the market risk premium, never R_m alone. When the question asks whether a stock is fairly priced, compute CAPM required return and compare it to the expected return derived from price and dividend.
The full lesson (about 1,637 words, 11 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 2B1
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