Risk

p RISK

a . This is diversifiable risk- This is because the risk is associated with the particular firm only . The risks do not concern any other firms in the industry

b ) This is undiversifiable risk- This is because an hurricane is a natural occurrence that cannot be avoided or diversified . It affects all firms in the two US cities

c ) This is undiversifiable risk- A large increase in the price of oil is caused by market factors and affects all firms in the same magnitude

d ) This is diversifiable risk- The

imprisonment of the CEO affects only that individual corporation . The risk can be diversified by taking appropriate measures to avoid similar occurrences

a )Expected rate of Return Rf ( Rm - Rf

Of portfolio

Whereby Rf Risk free rate

Rm Average market return Beta 1 .4 (4 - 1 .4 ) 1 .5 5 .3

b ) Expected rate of return Risk free ( expected return _ Risk free ?eta

rate on the market rate

I .e . R Rf ( Rm-Rf

8 Rf (8 - Rf ) 1 .3

8 Rf 1 .3 (8 - Rf

8 -10 .4 Rf - 1 .3 Rf

-2 .4 - 0 .3Rf

Rf 2 .4 8

0 .3

c ) The Beta would be lower with half of the stocks invested in major exchanges . This is because by diversifying investments in other companies , one would in essence be reducing his risk . This is referred to as portfolio risk diversification . But with all

Stocks invested in only one single company , it is like `putting one 's eggs in one basket . The beta factor will therefore be higher

3 . Drawbacks of using CAP M

CAP M assumes that only systematic risk exists in the market . However both systematic and unsystematic risks exist in the market . It also assumes that the market is perfect and efficient . However in real world perfect efficiency markets are difficult to exist

The beta factor is an estimate based on historical or past data . It cannot therefore accurately be used to compute the expected rate of return

The tool also assumes that all investors are risk averse but in reality some are risk seekers . There is that group of investors that will go for higher risk for the same return of the stocks . There are also those ones who would prefer lower return stocks having the same risk . CAP M also assumes that there are no corporate taxes and other costs (transaction .B

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b

A

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ensitive an asset is to market risk and the average return in the market

CAP M also acts intuitively since its assumption of `the higher the risk , the higher the return ' has been the core guide to investors

REFERENCES

Mullins , David W . Does the capital asset pricing mode work ' 1982 Harvard Business Review

Markowitz , Harry M . The early history of portfolio theory , 1999 Financial Analysts Journal

Ross , Stephen A , The capital asset pricing model ( CAP M , Short-Sale Restrictions and Related Issues , Journal of Finance...