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
- There’s a substantial unexpected increase in inflation.
- The substantial, unexpected increase in inflation is a non-verifiable risk that affects the overall price change in the market. This affects the investors in the way that it shifts socioeconomic parameters, global security threats, and changes the prices of the commodities in the market. Non-diversifiable, also characterized as Systematic Risk, is not controllable by investors.
- There’s a major recession in the U.S.
- Recession typifies the phase of impermanent economic decline during which business activity is lessened. It is depicted by a plunge in GDP in successive quarters. The recession in the US exemplifies non-diversifiable risks since it causes the price of commodities to intensify, a significant problem to many investors in US (Money Chimp, 2010).
- A major lawsuit is filed against one large publicly traded corporation.
- A major lawsuit filed against one large publicly traded corporation is a diversifiable risk since it is specific to a sector, and hence, its impact on a diversified portfolio is limited. This will only affect the investors holding shares in the company. The interest rate of the shares will augment, meaning that the investors will not be able to diversify interest rate risks.
Use the CAPM to answer the following questions
Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset “i” is 12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset “i” is 1.2.
Expected Return Rate: (Investopedia, 2010)
Kc = Rf + beta x (Km – Rf )
Where;
- Kc is the risk-adjusted discount rate (also known as the Cost of Capital);
- RF is the rate of a “risk-free” investment, i.e. cash;
- Km is the expected market return rate.
- Kc =0.04+1.2(0.12-0.04)
- Kc = 0.04 +1.2 (0.08)
- Kc = 0.04 + 0.096 = 0.136
Find the Risk-Free Rate given that the Expected Rate of Return on Asset “j” is 9%, the Expected Return on the Market Portfolio is 10%, and the Beta (b) for Asset “j” is 0.8.
- 0.1=Rf +0.8(0.09-Rf)
- 0.1=Rf+0.8*0.09-0.8Rf
- 0.1=Rf-0.8Rf+0.8*0.09
- 0.1=Rf (1-0.8) +0.8*0.09
- 0.1=Rf (0.2) +0.8*0.09
- Rf (0.2) =0.1-0.8*0.09
- Rf=0.1-0.8*0.09/0.2 = 4.64
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.
If half of the stocks will be traded in significant exchanges, the beta will lessen by half, since it shows how much the price of the stock changes compared with how much the stock market changes in the market. Damodaran (2007) argues that if a share price moves precisely in line with the market stocks, the stock’s beta is expected to be one. Therefore, if the stocks decrease by half, the beta will also decrease by half.
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?
The general suggestion behind Capital Asset pricing model to investors and the corporation are that they are required to calculate the time value of money and risk involved in the commodities they intend to invest in the market. The Time Value of Money compensates the investors for investing in any undertaking over a phase. The other part of the formula represents risk involved in investment: it calculates the amount of compensation the investor and the corporation will be required to use for taking on additional risk.
This is calculated by taking a Risk Measure (beta) that contrasts returns of the asset to the market over a phase and to the Market Premium (Rm-rf). When it comes to analyzing the risk label involved on securities, investors and the corporation are expected to consider the CAPM to make sure risk decision are undertaken wisely. According to Sharpe (2008), the goal of CAPM to the investors is to determine a required rate of return to justify adding asset or commodities to an already well-diversified portfolio. Considering that asset’s are non-diversifiable risks, and they are affected by the change of the prices of the commodities in the market.
No matter how much the investors try to diversify the investments, it is impossible to do away with of all the risk involved on these assets. Therefore, the investors and the corporation should consider the rate of return that will compensates them for taking the risk. The investors should calculate investment risk and the return on investment expected to realize by use of CAPM in their analysis.
The model shows that, the risk can be avoided by the investors through diversification of the asset they are investing in the market. The diversification will not unravel the dilemma of systematic risk (Risk and Return, 1991); even a portfolio of all the shares in the stock market cannot eliminate that risk. Therefore, what the investors should determine is when to calculate a deserved return on the asset systematic risk.
References
Damodaran, A. (2007). Picking the right projects: Investment analysis.
Investopedia. (2010). Capital Asset Pricing Model- CAPM. Investopedia.
Money Chimp. (2010). CAPM calculator.
Risk and Return. (1991). The Economist, 318, 72-73. Web.
Sharpe, W. (2008). Capital Asset Pricing Model. Value Based Management. Web.