ormarketrisk.Inthissection,wediscussthedifferentmodels
formeasuringmarketriskandwhytheydiffer.Webeginwith
whatstillisthedefaultmodelformeasuringmarketriskin
finance—thecapitalassetpricingmodel(CAPM)—andthen
discuss the alternatives to this model that have been
developed over the past three decades.
To see thebasis forthe CAPM,consideragain whymost
investors stop diversifying, the diversification benefits
notwithstanding. First, because the marginal gain to
diversifyingdecreaseswitheachadditionalinvestment,ithas
tobeweighedoffagainstthecostofthataddition.Evenwith
smalltransactions costs,therewillbe apointatwhich the
costs exceed the benefits. Second, most active investors
believethattheycanpickundervaluedstocks(i.e.,stocksthat
willdobetterthantherestofthemarket).TheCAPMisbuilt
ontwokeyassumptions:Therearenotransactionscosts,and
investors have no access to private information (allowing
them to find undervalued or overvalued stocks). In other
words,itassumesawaythetworeasonswhyinvestors stop
diversifying.Bydoingso,itensuresthatinvestorswillkeep
diversifyinguntiltheyholdapieceofeverytradedasset—the
marketportfolio,inCAPMparlance—andwilldifferonlyin
termsofhowmuchoftheirwealththeyinvestinthismarket
portfolioandhowmuchinarisklessasset.Itfollowsthenthat
therisk of any asset becomesthe riskthat itadds to this
marketportfolio.Intuitively,ifanassetmovesindependently
ofthemarketportfolio,itwillnotaddmuchrisktothemarket
portfolio. In other words, all of the risk in this asset is
firm-specificandcanbediversifiedaway. Incontrast,ifan
assettendstomoveupwhenthemarketportfoliomovesup
anddownwhenitmovesdown,itwilladdrisktothemarket
portfolio. This asset has more market risk and less