CAPM

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Part 1

An undiversifiable risk is a risk that can be said to be common when one considers a given assets or liabilities class. On the other hand, a diversifiable risk is a price change risk that is informed by a given securities circumstances which can be taken to be largely unique. With regard to a fire that severely damages three major US cities, this can be said to be an undiversifiable risk. This is because such an occurrence would affect entire markets.


When it comes to a substantial unexpected rise in the price of oil, this can be said to be a diversifiable risk as such an occurrence would affect only a few counters as opposed to large market portions as in the previous scenario. Next, when it comes to a major lawsuit being filed against one large publicly traded corporation, this can be said to be a diversifiable risk because it shall not affect the overall market.


Part 2

Ks = Krf + B (Km – Krf); where Ks is the expected rate of return, Krf is the risk free rate, B is beta and Km is the expected rate of return on asset.

Therefore, for part a) we have Ks = 0.03 + 1.5 (0.01 + 0.03), hence in this case, the expected rate of return, that is, Ks shall be 0.09

For part b) we have 0.14 = Krf + 1.5 (0.12 + Krf)

0.14 = Krf + 0.18 + 1.5krf

0.14 = 2.5Krf + 0.18

-0.04 = 2.5Krf

-0.016 = Krf


This essentially Means that the risk f=re rate in this case is -0.016

When it comes to part c) If I owned half of all the stocks traded, the beta of my stock portfolio would be 0.5. This is essentially because the beta or the overall risk of investing in a big market is usually 1.0000.


Part 3

Message of the CAPM to corporations and investors

When it comes to corporations, CAPM is essentially critical when it comes to the computation of the cost of equity for a wide of purposes including but not in any way limited to business combinations i.e. merger and acquisition deals as well as for purposes of capital budgeting. It is hence important to note that for corporations, CAPM is largely a strategic planning tool that is critical as far as decision making is concerned at the organizational level. According to Focardi et al. (2004), CAPM goes a long way to complement the other analytical tools effectively within an organization.


When it comes to investors, CAPM seems to indicate that by virtue of diversification being utilized widely to eliminate or limit individual assets risks, the overall market risk is the only risk that investors should fret or be worried about. It is important to note that when it comes to seeking compensation or returns from their investments, investors look for payment as a result of having their cash held up for quite a while and on the other hand investors need t be compensated additionally for the probability that the performance of the investment may not be as expected.


Therefore, it is important to note that the investment must earn a rate of interest that is risk free as a way of compensating for the held up funds. Similarly, the market return is what the investment must earn so as to compete for uncertainty. However, this market return must be adjusted for the market risk exposure amount. When it becomes to the construction of portfolios as well as pricing of securities, investment professionals rely on CAPM.


 References

Focardi, S. & Fabozzi, F.J. (2004). The mathematics of financial modeling and investment management. John Wiley and Sons

 

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