## Risk Classification under the CAPM Approach
Under the Capital Asset Pricing Model (CAPM), the total risk of a security is split into two groups.
### 1. Unsystematic Risk (Company-specific / Diversifiable)
- Related to the individual company's performance.
- Can be reduced or eliminated by diversifying the securities portfolio.
- Also called diversifiable risk.
### 2. Systematic Risk (Market-specific / Non-diversifiable)
- The macro-economic or market-wide risk under which every company operates.
- Cannot be eliminated by diversification.
- Examples: inflation, government policy, interest-rate changes.
### Why CAPM focuses only on systematic risk
Since an investor can eliminate diversifiable (unsystematic) risk through diversification, only the non-diversifiable (systematic) risk remains relevant. Therefore, under CAPM, a business should be concerned solely with non-diversifiable risk.
This non-diversifiable risk is measured by the beta coefficient (β), obtained by fitting a regression between the return on the security and the return on the market portfolio.
### The CAPM formula (context)
$$K_e = R_f + \beta(R_m - R_f)$$
- $R_f$ = risk-free rate of return
- $\beta$ = beta coefficient
- $R_m$ = return on the market portfolio
- $(R_m - R_f)$ = market risk premium
## Shortcomings of the CAPM Approach
a. Estimation of beta using historical data is unrealistic — past beta may not hold in the future.
b. Market imperfections may expose investors to unsystematic risk that the model assumes away.