Which risk does the market pay for?
Systematic and unsystematic risk, CAPM and its limits
Rolandas Rakštys · Lecturer · Vytautas Magnus University, Agriculture Academy · Faculty of Bioeconomy Development, Department of Business and Rural Development · [email protected] · ORCID 0000-0003-0299-9930
Chapter 3 “Business risk and profitability”, section 3.1.2 (part 1 of 2) · English translation of chapter v1.14.4 (2026-10-31) · set v1.0 · 16 slides, ≈ 25 min
Rakštys, R. (2026). Chapter 3. Business risk and profitability (English translation of v1.14.4, 2026-10-31). Verslo planavimas ir vertinimas [Business planning and evaluation]. Vytautas Magnus University, Agriculture Academy. https://rakstys.eu/studijos/verslo-planavimas-ir-vertinimas/en/skyriai/ch03/ · CC BY-NC-ND 4.0
One company – two risks
The same company, the same fire.
A trifle to the investor, everything to the owner. So why does the market pay for only part of the risk?
Unsystematic and systematic risk
Eliminated by diversifying
Cannot be diversified away – the market pays a risk premium for it
Where would you place this card?
Variance in two parts
During crises the correlations between assets rise dramatically – precisely when diversification is most needed (Campbell, Koedijk & Kofman, 2002).
Why risk costs the owner more
A diversified investor
Prices only systematic risk.
The owner of a private business
Wealth concentrated in a single firm – cannot diversify unsystematic risk away.
The owner effectively bears a higher risk premium.
Valuing private businesses – Chapter 14, exit strategies – Chapter 18: the possibility of diversification is one of the factors that create value.
Diversification has limits
The argument
Investing in different countries reduces the risk of a national economy, because national cycles do not coincide.
The counter-argument
As markets integrate, correlations increase over time – and during crises they increase still further.
Two different layers of risk – in plans they are often treated as one.
When diversification destroys value
The conglomerate discount
A discount of roughly 13–15 % (Berger & Ofek, 1995)
“Diworseification”
diversification + worse (Lynch & Rothchild, 1989)
Managerial complexity, a lack of synergies, the inefficient allocation of capital.
Portfolio diversification reduces unsystematic risk.
Corporate diversification creates value for the shareholder only when it delivers what the investor cannot achieve by himself: synergies, cheaper capital or new capabilities.
If there is no increment, all that remains is higher managerial costs. Decisions on diversification and specialisation are discussed more fully in Chapter 5.
Compensation for systematic risk
An investor demands compensation for the risk assumed.
The capital asset pricing model (CAPM): the risk premium depends only on systematic risk.
β = 1 – the asset moves with the market.
The formulas with numbers are in section 3.2; their practical application to the discount rate and to the weighted average cost of capital (WACC) is in Chapter 11.
Three, then five factors
Empirical research has revealed systematic anomalies that CAPM is unable to explain.
Compensation for risk
Fama and French interpret the factors as risk factors.
A consequence of cognitive errors
Proponents of behavioural finance – as market inefficiency (Lakonishok, Shleifer & Vishny, 1994).
A theory that does not name its factors
APT (Ross, 1976)
Arbitrage Pricing Theory (APT) allows several sources of systematic risk and does not require a “market portfolio”.
The advantage is flexibility. The drawback: it does not state which factors are important.
Roll and Ross (1980)
US equities, 1962–1972: “at least three, probably four”
Cho (1984)
a different method: “five or six”
Both studies: there is no basis for rejecting APT – but not over the number of factors. They agree on the conclusion, not on the number: that is what a theory which does not name its factors means.
The equity premium puzzle
US equity market · 1889–1978
The difference between this figure and the observed one is the puzzle. Almost six percentage points are missing.
Two explanations of the puzzle
Several theoretical explanations have been proposed over the past decades. Two of them:
Habit formation (Campbell & Cochrane, 1999)
Utility depends also on the previous level of consumption – the habit. When consumption falls below the habit, the negative utility is disproportionately large.
The rare disasters model (Barro, 2006)
Investors expect rare but catastrophic downturns, and therefore demand a high premium even in periods when no catastrophe materialises.
Neither the premium nor beta is constant
The risk premium
Depends on the phase of the cycle and on the calendar: seasonality, for example the January effect (Corhay et al., 1987).
The sign of the excess return
Forecast by probit models whose explanatory variables include indicators of recession (Nyberg, 2011). If the premium were constant, there would be nothing to forecast.
Beta
Non-stationary: over different horizons the same asset may have a very different beta (Huang, 2001).
Does CAPM work? Depends how often you ask.
CEE markets (Dajčman et al., 2013)
In the small-capitalisation, low-liquidity markets of Central and Eastern Europe (CEE), CAPM performs considerably worse. In the Baltic context – caution and supplements: multi-factor models or scenarios.
Is bankruptcy risk systematic?
Dichev (1998): if bankruptcy risk is systematic, CAPM ought to compensate it with a higher expected return.
Firms with a high probability of bankruptcy do not have a correspondingly higher return – since 1980 it has been lower than the average.
A risk-based explanation does not account for this regularity – the anomaly remains without an agreed theoretical foundation.
Through the investor’s and the owner’s eyes
Through the investor’s eyes
He diversifies unsystematic risk away; the market pays him for the systematic kind.
CAPM, Fama and French, APT – with open empirical problems: a varying premium, an unstable beta.
Through the owner’s eyes
He cannot diversify unsystematic risk away – and effectively bears a higher risk premium.
Corporate diversification benefits him only where there is an increment; bankruptcy risk needs instruments of its own.
For discussion · question 3.10. Why does CAPM state that the market does not compensate unsystematic risk? Does this mean that the owner of a private business whose wealth is concentrated in a single firm is taking an irrational decision? Justify your position. Next – part 2: “What to do with risk”.
References
Barro, R. J. (2006). Rare disasters and asset markets in the twentieth century. The Quarterly Journal of Economics, 121(3), 823–866.
Berger, P. G., & Ofek, E. (1995). Diversification's effect on firm value. Journal of Financial Economics, 37(1), 39–65.
Campbell, J. Y., & Cochrane, J. H. (1999). By force of habit: A consumption-based explanation of aggregate stock market behavior. Journal of Political Economy, 107(2), 205–251.
Campbell, R., Koedijk, K., & Kofman, P. (2002). Increased correlation in bear markets. Financial Analysts Journal, 58(1), 87–94.
Cho, D. C. (1984). On testing the arbitrage pricing theory: Inter-battery factor analysis. The Journal of Finance, 39(5), 1485–1502. https://doi.org/10.1111/j.1540-6261.1984.tb04919.x
Corhay, A., Hawawini, G., & Michel, P. (1987). Seasonality in the risk-return relationship: Some international evidence. The Journal of Finance, 42(1), 49–68.
Dajčman, S., Festić, M., & Kavkler, A. (2013). Multiscale test of CAPM for three Central and Eastern European stock markets. Journal of Business Economics and Management, 14(1), 54–76. https://doi.org/10.3846/16111699.2011.633097
Dichev, I. D. (1998). Is the risk of bankruptcy a systematic risk? The Journal of Finance, 53(3), 1131–1147.
Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33(1), 3–56.
Fama, E. F., & French, K. R. (2015). A five-factor asset pricing model. Journal of Financial Economics, 116(1), 1–22.
Handa, P., Kothari, S. P., & Wasley, C. (1993). Sensitivity of multivariate tests of the capital asset-pricing model to the return measurement interval. The Journal of Finance, 48(4), 1543–1551. https://doi.org/10.1111/j.1540-6261.1993.tb04767.x
Huang, H.-C. (2001). Tests of CAPM with nonstationary beta. International Journal of Finance & Economics, 6(3), 255–268.
Lakonishok, J., Shleifer, A., & Vishny, R. W. (1994). Contrarian investment, extrapolation, and risk. The Journal of Finance, 49(5), 1541–1578.
Lynch, P., & Rothchild, J. (1989). One Up on Wall Street: How to Use What You Already Know to Make Money in the Market. Simon & Schuster.
Mehra, R., & Prescott, E. C. (1985). The equity premium: A puzzle. Journal of Monetary Economics, 15(2), 145–161. https://doi.org/10.1016/0304-3932(85)90061-3
Nyberg, H. (2011). Forecasting the direction of the US stock market with dynamic binary probit models. International Journal of Forecasting, 27(2), 561–578. https://doi.org/10.1016/j.ijforecast.2010.02.008
Roll, R., & Ross, S. A. (1980). An empirical investigation of the arbitrage pricing theory. The Journal of Finance, 35(5), 1073–1103.
Ross, S. A. (1976). The arbitrage theory of capital asset pricing. Journal of Economic Theory, 13(3), 341–360.
Rakštys, R. (2026). Chapter 3. Business risk and profitability (English translation of v1.14.4, 2026-10-31). Verslo planavimas ir vertinimas [Business planning and evaluation]. Vytautas Magnus University, Agriculture Academy. https://rakstys.eu/studijos/verslo-planavimas-ir-vertinimas/en/skyriai/ch03/ · CC BY-NC-ND 4.0
These slides are based on the textbook Verslo planavimas ir vertinimas [Business planning and evaluation]. The text was translated, structured and visually laid out with the help of artificial intelligence tools (Claude), following the protocol for working with AI and the verification procedures set by the author.