Systematic Risk in Finance
Systematic risk plays a key role in portfolio allocation. Risk which cannot be eliminated through diversification commands returns in excess of the risk-free rate (while idiosyncratic risk does not command such returns since it can be diversified). Over the long run, a well-diversified portfolio provides returns which correspond with its exposure to systematic risk; investors face a trade-off between returns and systematic risk. Therefore, an investor's desired returns correspond with their desired exposure to systematic risk and corresponding asset selection. Investors can only reduce a portfolio's exposure to systematic risk by sacrificing returns.
An important concept for evaluating an asset's exposure to systematic risk is Beta. Since Beta indicates the degree to which an asset's expected return is correlated with broader market outcomes, it is simply an indicator of an asset's vulnerability to systematic risk. Hence, the capital asset pricing model (CAPM) directly ties an asset's equilibrium price to its exposure to systematic risk.
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