Why is it only the covariance of an asset's return with the return on the world market portfolio that determines whether there is a risk premium associated with the asset's expected return?
What will be an ideal response?
The uncertain part of an asset's return can be broken into two components. The non-diversifiable part is determined by the covariance of the return on the asset with the return on the market portfolio. This part is the source of risk and the part that gives rise to a risk premium on the asset. The other component of the uncertain part of an asset's return is the part that is diversifiable and therefore does not contribute to the variance of a large, well-diversified portfolio. This latter part is therefore not a source of risk to an investor who holds a large, well-diversified portfolio.
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What will be an ideal response?
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