Zero-beta risks and required returns: ESG and CAPM

Abstract

We ask how idiosyncratic zero-beta risks (e.g., the risk of litigation or R&D failing) affect the firm's cost of capital under capital asset pricing model (CAPM). Surprisingly, perhaps, CAPM theory reveals that adding an idiosyncratic risk to the firm's payoff distribution will usually although not necessarily increase the firm's cost of capital. Lintner's famous original CAPM expositions revealed that the firm's CAPM cost of capital is a function of the ratio of the covariance of its cash payoff with the market to its payoff mean. Lintner proved that an idiosyncratic risk that affects the firm's payoff covariance per unit of mean is“priced” in the sense that it necessarily alters the firm's CAPM discount rate. We explain and clarify Lintner's argument using elementary CAPM equations and numerical examples.