1. For each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
a. A large fire severely damages three major U.S. cities
A prudent investor can diversify risks that are unique to a particular city or cities by investing in many cities. A fire that destroys three cities will create an advantage to suppliers in other cities by creating a deficit in supply of some commodities. This is therefore a diversifiable risk. However, an investor must be aware that the US market is very sensitive to any slight change (Damodaran 2002).
b. A substantial unexpected rise in the price of oil
Generally, fluctuations in the prices of oil have an effect on the entire economy since they change the liquidity of money in circulation. For instance, unexpected appreciation in the prices of oil can bring about inflationary effects in the entire economy hence it is an undiversifiable risk.
c. A major lawsuit is filed against one large publicly traded corporation
A lawsuit against the corporation is unique to that particular organization and will not affect the entire economy. This is therefore a diversifiable risk as the investor can diversify such a risk by investing in several corporations of public and private nature.
2. Use the CAPM to answer the following questions:
a. Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset “i” is 10%, the Risk-Free Rate is 3%, and the Beta (b) for Asset “i” is 1.5.
Ri = Rf + βi (Rm – Rf)
Where:
Ri – expected rate of return on the asset (i)
Rf – risk free rate
βi – beta
Rm – market rate of return
Rm = ((Ri – Rf)/ βi) + Rf
= ((0.1 – 0.03)/1.5) + 0.1
= 0.14666666666666666…
= 0.14667
= 14.67%
b. Find the Risk-Free Rate given that the Expected Rate of Return on Asset “j” is 14%, the Expected Return on the Market Portfolio is 12%, and the Beta (b) for Asset “j” is 1.5.
Rj = Rf + βj (Rm – Rf) Where:
Rj – expected rate of return on the asset (j)
Rf – risk free rate
βi – beta
Rm – market rate of return
Rf (1 – βj) = (Rj – βjRm)
Rf = (Rj – βjRm)/ (1 – βj)
= (0.14 – 1.5*.12)/ (1-1.5)
= 0.08
= 8%
c. What do you think the Beta (β) of your portfolio would be if you owned half of all the stocks traded on the major exchanges? Explain.
The beta is likely to be one. This is because owning half of all the stocks traded is likely to subject the portfolio to similar behavior where the stocks are likely to move in the same direction in response to market dynamics. However, this can only be true where the change taking place in the stocks is equals that of index value in magnitude. If the two are not equal then the portfolio beta will be higher where it changes by a bigger percentage. On the same note, it will be less than where it changes by a lower percentage as compared to the index (Flynn et al 2007).
3. In one page explain what you think is the main ‘message’ of the Capital Asset Pricing Model to corporations and what is the main message of the CAPM to investors?
Corporations have many ways in which they can benefit from the information obtained from CAPM. Even though the application of the information depends on the particular corporation and the industry it operates, CAPM is used generally for striking a balance between the risk on investment and the return that the same investment yields. Investment managers in corporations use CAPM to assess their investment decisions, evaluate the potential of returns on their portfolios (Emery et al 2007).
On the other hand, capital asset pricing model can be applied by investors in their investment decisions in a number of ways. Principally, the message the capital asset pricing model gives an investor is to invest in a portfolio that gives maximum economic utility to the investment made (Damodaran 2002).
Reference List:
Emery, D., Finnerty, J & Stowe, J. (2007). Corporate Financial Management. Upper-Saddle-River: Prentice Hall
Damodaran A. (2002) Investment valuation: tools and techniques; 2nd Edition, John Wiley and Sons: 732 – 752
Flynn, D. Carlos C., Enrico U., & Michael W. (2007) Financial Management; Juta and Company Limited; 21 – 27