According to Focardi & Fabozzi (2004), a diversifiable risk can be taken to be a price change risk as a result of circumstances that are largely unique in regard to a given security in contrast to the entire market. With that in mind, it is possible to eliminate this risk (rather virtually) as far as a portfolio is concerned by use of diversification. On the other hand, an un-diversifiable risk can be taken to be a risk which affects a given asset class or liabilities in their entirety.
When it comes to a substantial unexpected increase in inflation; this can be taken to be an un-diversifiable risk. This is essentially because an increase in inflation is bond to affect the entire class of assets/overall market as opposed to only a single security.
A major recession in the United States is another example of an un-diversifiable risk. Again, a major recession would go ahead to affect the entire markets as opposed to a single counter of securities or assets. One of the ways to protect against his kind of risk would be through asset allocation.
When it comes to a major lawsuit filed against one large publicly traded corporation, this would represent a diversifiable risk. This is because such a development would affect only the securities of that specific publicly traded corporation as opposed to the entire market. Again, it is important to note that this kind of risk can be reduced through strategies such as diversification.
Ks = Krf + B (Km – Krf);
Ks= expected rate of return
Krf = risk free rate
Km = the expected rate of return on asset
Ks = 0.04 + 1.2 (0.12 + 0.04) which gives us an expected rate of return of 0.352
0.09 = Krf + 0.8 (0.10 + Krf)
0.09 = Krf + 0.08 + 0.8krf
0.09 = 0.9krf + 0.08
Krf = 0.19
Hence in this case, we have a risk free rate of 0.19
For part c), it is important to note that the overall investing risk or beta when it comes to investing in substantial markets is given as 1.0000. Therefore, if I had the ownership of the traded stocks, my portfolioâ€™s beta would be 0.5.
CAPM: message to investors and corporations
In regard to corporations, Focardi & Fabozzi (2004) is of the opinion that the cost computation largely depends on CAPM. It is important to note that the cost of equity computation is essentially for a wide range or reasons including capital budgeting as well as the sealing of deals in mergers and acquisitions. Corporations are hence increasingly utilizing CAPM as a tool for strategic planning and this goes a long way to enhance the organizational level decisions. It can also be noted that in the modern day, CAPM has come to be embraced as a complement for the various organizational analytical tools.
As far as investors are concerned, CAPM postulated that investors should only spend sleepless nights or worry about the overall market risk. This is essentially because as far as the limiting or elimination of asset risks (individual) is concerned, all that is required in most instances is diversification. As far as compensation seeking or enhancement of investment returns, investors are essentially concerned with payment by virtue of the fact that their funds being held up for a significant amount of time. It can also be noted that the issue of compensation to investors comes up as their initial expectations with regard to the performance of their investments may not materialize. To compensate for all these factors, a given market return that is effectively adjusted for the amount of exposure to market risk must be earned by the investor. Investment professionals must hence rely more or less on the Capital Asset Price Model in securities pricing and portfolio construction.
Focardi, S. & Fabozzi, F.J. (2004). The mathematics of financial modeling and investment management. John Wiley and Sons
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