The aim of this essay is to consider the concepts of diversifiable and undiversifiable risks, assign these types of risks to different real cases, and perform calculations of the expected rate of return for particular assets, and finally, analyze the meaning for CAPM equation for investors and for corporations.
Generally speaking, diversifiable risks are the risks being relatively insignificant when many positions are considered in the portfolio and the law of large numbers starts working (Bruni & Fair & O’Brien & Allen 1996). In other words, diversifiable risks are those related to one company or to some local phenomenon. Undiversifiable risks are the risks which remain significant even when many positions are considered and the law of large numbers takes place (Bruni & Fair & O’Brien & Allen 1996). Thus, undiversifiable risks impact the whole market, and refer to global phenomenon, or to events influencing the whole state of economy.
Considering the given cases, case A (a large fire severely damages three major U.S. cities) is the example of undiversifiable risk since the economy will be significantly influenced by such fire, and all markets are likely to experience recession. Analogously, case B (a substantial unexpected rise in the price of oil) is also undiversifiable because oil prices have a large impact on the economy and on price level. Case C (a major lawsuit is filed against one large publicly traded corporation) is the example of diversifiable risk, because one corporation does not represent the whole market, and this risk can be diversified by investing into assets of other companies.
CAPM equation has the following form (Ehrhardt & Brigham 2009):
where is the expected return on a security, is a risk free rate, is expected market return, and is the measure of risk, i.e. beta of the security.
a. find the expected rate of return on the market portfolio given that the expected rate of return on asset is 10%, the risk-free rate is 3%, and the beta for asset is 1.5.
Expected rate of return on the market portfolio is 7.67% for this case
b. find the risk-free rate given that the expected rate of return on asset is 14%, the expected return on the market portfolio is 12%, and the beta for asset is 1.5.
Risk free rate for this case equals 8%.
c. What do you think the beta of your portfolio would be if you owned half of all the stocks traded on the major exchanges? Explain.
Beta indicates volatility of the portfolio compared to market behavior, and serves as the indicator of risk, or the indicator of portfolio sufficient diversification. Thus, the more stocks are owned, the less risk is experienced. On the other hand, the larger part of market is owned, the closer is the behavior of the portfolio to general market behavior.
Most likely, the value of portfolio beta will approach to 1 in this case.
The CAPM method may be used by corporations in order to calculate the cost of equity for capital budgeting (Ehrhardt & Brigham 2009), as well as for the purposes of business combination and for rate settings by public utilities. CAPM message to investors includes the possibilities for constructing portfolios, pricing securities, risk minimization and diversification of the investments.