1. From viewpoint of investors, are these diversifiable risks or not? Explain.

A diversifiable risk is one that can be reduced by including more assets in the portfolio.

a.  A large fire damages three major US cities. Diversifiable. A company can purchase shares in a similar company that serves mutually exclusive geographic markets, in addition to purchasing shares in companies that are not affected by the US economy.

b.  A substantial unexpected rise in the price of oil. Undiversifiable. This risk will likely affect the values of all stock in a portfolio. However, hedges against price increases in oil can be purchased.

c.  A major lawsuit is filed against one large publicly traded corporation. Diversifiable. Risks specific to a single company in a portfolio. An investor could purchase shares in another company in the same industry to help minimize risk.

2. Use the CAPM to answer the following.

CAPM formula:

(Expected Return on an asset) – (Risk Free Rate) = Expected Market Return – Risk Free Rate

Beta of Asset

a.  Find expected Market Return given:

ROA = 10%

RFR = 3%

Beta = 1.5

(10% - 3%)/(1.5) = X – 3%

(7)/(1.5) + 3% = X

X = 7.67% = Expected Market Return

b.  Find RFR given:

Expected Asset return = 14%

Expected Market return = 12%

Beta for asset = 1.5

(14% - RFR)/1.5 = 12% - RFR

14% - RFR = 1.5*(12% - RFR)

14% - RFR = 18% - 1.5*(RFR)

.5*RFR = 4%

RFR = 8%

c.  The Beta for a portfolio that contained half of the stocks traded on the major exchanges would be very close to 1, assuming that the stocks were chosen at random. Since Beta is a measure of the sensitivity of an asset (portfolio) to the market return, as you add more and more stocks randomly into your portfolio the value of Beta will approach the Beta of an asset against itself…which is one.

3.  In one page, explain the main message of the CAPM to corporations. To investors?

The core theory underlying the Capital Asset Pricing Model is that there are two types of risk inherent in an investment. Systematic (or undiversifiable) risk and unsystematic risk. Systematic risk is equivalent to the MARKET risk, and cannot be avoided when investing in the market. The unsystematic risk, however, IS avoidable through diversification.

This concept of minimizing your risk while pursuing a given return can be applied to corporations. The very nature of corporations requires that they engage in the practice of taking risks in the hopes of generating a desirable return. Can some of the risk of projects be eliminated through diversification? Consider the following case:

-  Having relationships with more than one vendor to provide you with necessary goods. If you have one vendor, and if for any reason they are unable to supply you with needed inputs, your business, project, and return may suffer. Having multiple relationships (diversifying your supply chain) may minimize this risk.

By undertaking decisions in a manner that helps eliminate unsystematic risk, companies may be able to reduce the volatility of their returns…or at the very least, eliminate some of the unnecessary risk inherent in projects. It should be the duty of every competent manager to eliminate unnecessary risk in their projects.

The message for investors is similar. Since diversified investment portfolios can be created that eliminate 100% of the unsystematic risk, investors would be foolish to take on any risk above the market risk. Once all systematic risk is eliminated, investors will also have a better idea of the required rate of return on their money, given the level of investment risk that remains. When comparing the riskiness of various portfolios that have been properly diversified, investors can balance their desire for return against their risk tolerance and more accurately choose a portfolio that suits their needs and provides the greatest return for the least amount of risk possible for that specific investment.