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Application of the Capital Asset Pricing Model

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. There's a substantial unexpected increase in inflation.
b. There's a major recession in the U.S.
c. A major lawsuit is filed against one large publicly traded corporation.

2. Use the CAPM to answer the following questions:
http://en.wikipedia.org/wiki/Capital_asset_pricing_model

a. 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.
b. 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.
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.

3. 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?

Solution Preview

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

As per money terms "Diversifiable risk is simply risk that is specific to a particular security or sector so its impact on a diversified portfolio is limited. An example of a diversifiable risk is the risk that a particular company will lose orders."
http://moneyterms.co.uk/diversifiable-risk/

Hence Undiversifiable risk is a common risk related to the economy.
http://www.investorwords.com/3318/nondiversifiable_risk.html

a. There's a substantial unexpected increase in inflation.
This is an Undiversifiable risk as it's a common risk related to the economy.

b. ...

Solution Summary

Questions are answered in 502 words with calculations clearly shown and displayed. Concepts of CAPM, Risk-Free Rates and Beta are covered among others.

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