Zero -Beta Risks and Required Returns: ESG and CAPM

Abstract

We ask how idiosyncratic zero-beta risks (e.g., the risk of tighter regulation or R&D failing) a¤ect the …rm's cost of capital under CAPM. Surprisingly, perhaps, CAPM theory reveals that adding an idiosyncratic risk to the …rm's payo¤ distribution must typically increase the …rm's cost of capital. If the new zero-beta activity or risk will at best result in no loss, it has negative expected payo¤, its CAPM price is negative, and its e¤ect on the …rm's overall beta and cost of capital must be positive (it drags the …rm's cost of capital away from the risk-free rate). Conversely, when the mean payo¤ is positive, the cost of capital must fall. These results are proven using just CAPM equations (illustrated with examples) and traced directly to Lintner's famous papers and other citations from seminal CAPM theory.

Keywords: cost of capital, CAPM, idiosyncratic risk, ESG risks

JEL Classification: G10, G11, G12