Zero -Beta Risks and Required Returns: ESG and CAPM

29 Pages Posted: 30 Oct 2023

See all articles by David Johnstone

David Johnstone

University of Sydney Business School; Financial Research Network (FIRN)

Andrew R. Grant

University of Sydney Business School - Discipline of Finance; Financial Research Network (FIRN)

Date Written: October 4, 2023

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

Suggested Citation

Johnstone, David and Grant, Andrew R., Zero -Beta Risks and Required Returns: ESG and CAPM (October 4, 2023). Available at SSRN: https://ssrn.com/abstract=4592682 or http://dx.doi.org/10.2139/ssrn.4592682

David Johnstone (Contact Author)

University of Sydney Business School ( email )

Instute of Transport and Logistics Studies (C37)
The University of Sydney
Sydney, NSW 2133
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Andrew R. Grant

University of Sydney Business School - Discipline of Finance ( email )

H69 Codrington Business School Building
Sydney, NSW 2006
Australia
61-2-9036-6238 (Phone)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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