Question

CAPM Regression Model o The last requirement EE r)0 is called exogeneity t mt » Ensures that movements in the market are not correlated, in any way, with movements in idiosvncratic rick » One way of thinking about this is that all systematic risk is explained by the market factor rmt- rf- o All left over risk can not be controlled, and is uncorrelated with the market factor o This assumption is required for us to decompose total risk El(r) into systematic risk o + β2E(r""-rg)-1 and idiosyncratic risk Ee - rh-| and idiosyncratic risk Ee

In the capm model, why E(ri-rf)² is measured as total risk. why do we need a square

Answer 1

risk is measured by variance
and variance is E((X-mean)^2)=E(X^2)-mean^2
As mean=0 so variance=E(X^2)