Reference no: EM132134779

Explain the systematic risk principle and how it relates to beta. according to the below message

SYSTEMATIC RISK AND BETA

The question that we now begin to address is this: What determines the size of the risk premium on a risky asset? Put another way: Why do some assets have a larger risk premium than other assets? The answer to these questions, as we discuss next, is also based on the distinction between systematic and unsystematic risk.

For more on beta, see money.cnn.com.

The Systematic Risk Principle

Thus far, we've seen that the total risk associated with an asset can be decomposed into two components: systematic and unsystematic risk. We have also seen that unsystematic risk can be essentially eliminated by diversification. The systematic risk present in an asset, on the other hand, cannot be eliminated by diversification.

Based on our study of capital market history, we know that there is a reward, on average, for bearing risk. However, we now need to be more precise about what we mean by risk. The systematic risk principle states that the reward for bearing risk depends only on the systematic risk of an investment. The underlying rationale for this principle is straightforward: Since unsystematic risk can be eliminated at virtually no cost (by diversifying), there is no reward for bearing it. Put another way: The market does not reward risks that are borne unnecessarily.

Systematic risk principle The expected return on a risky asset depends only on that asset's systematic risk.

The systematic risk principle has a remarkable and very important implication:

The expected return on an asset depends only on that asset's systematic risk.

There is an obvious corollary to this principle: No matter how much total risk an asset has, only the systematic portion is relevant in determining the expected return (and the risk premium) on that asset.