Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

In the ex post capital asset pricing model (CAPM), what does the error term represent?

1. The unexplained return attributable to misestimation of beta

2. The unexplained return attributable to misestimation of the riskless rate

3. The portion of the asset's excess return that is due to systematic risk

4. The portion of the asset's excess return that is due to idiosyncratic risk

The correct answer is: The portion of the asset's excess return that is due to idiosyncratic risk

In the ex post capital asset pricing model (CAPM), the error term indeed represents the portion of the asset's excess return that is due to idiosyncratic risk. Idiosyncratic risk refers to the inherent risk specific to a particular asset or company, which cannot be attributed to market movements or systematic influences. In other words, it reflects the unique factors that can affect the asset's return, including company performance, management decisions, and industry conditions that are not captured by the market as a whole. The ex post CAPM attempts to quantify expected returns based on systematic risk as defined by beta, which measures sensitivity to market movements. However, not all variations in returns can be explained by systematic risk; some will remain unexplained and will be classified as idiosyncratic risk. This is where the error term comes into play, highlighting the discrepancy between the expected return, derived from the model based on systematic risk, and the actual return experienced by the asset. The other aspects mentioned in the options relate to misestimations or components of risk that are not represented by the error term in this context. The error term specifically captures risk that is not systematic in nature, reinforcing the understanding of the duality of risk in asset pricing