Title

How an idiosyncratic (zero-beta) risk can greatly increase the firm’s cost of capital

Publication Name

Australian Journal of Management

Abstract

The celebrated capital asset pricing model (‘CAPM’) brought numerous appealing insights and spawned a new theory of capital budgeting. One key intuition is that there is ‘no penalty for diversifiable risk’ – that is, any risky payoff that has zero-correlation with the wider economy, and hence zero-beta, is treated as ‘risk-free’. Does that mean that managers can bet the firm on a spin of the roulette wheel without attracting a higher CAPM discount rate? Our re-interpretation of CAPM reveals that potential financial losses which are conventionally regarded as firm-specific ‘unpriced’ risks can bring a large increase in the firm’s beta and CAPM cost of capital, despite having zero-beta and making only negligible difference at the aggregate market level. This mathematical result clashes with textbook expositions but is easily demonstrated and can be traced to authoritative but overlooked parts of the theoretical CAPM literature. JEL Classification: G11, G12.

Open Access Status

This publication is not available as open access

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Link to publisher version (DOI)

http://dx.doi.org/10.1177/03128962211059576