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Application of CAPM

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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. A large fire severely damages three major U.S. cities.
b. A substantial unexpected rise in the price of oil.
c. A major lawsuit is filed against one large publicly traded corporation.

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.
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.
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.

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?

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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.

a. A large fire severely damages three major U.S. cities.
b. A substantial unexpected rise in the price of oil.
c. A major lawsuit is filed against one large publicly traded corporation.

First, I want to give you a reminder on what diversifiable risk is, and what undiversifiable risk is. Diversifiable risk, in relation to securities, is simply where you can eliminate your risk by owning many securities. Undiversifiable risk is where you cannot eliminate risk by owning more than 1 of something, or making one contingency plan, etc. These are the risks that are not able to be avoided. In short, diversifiable risk can be avoided, nondiversifiable cannot. It's important to note that sometimes you can have both at the same time.

A: I would say this is diversifiable. If I were a large company making investments in each of those three cities, I could minimize the risk that all three would catch fire by spreading out my investments to 5 or 10 cities (this could be factories, offices, etc). If your company doesn't have those resources, and you are only operating in 3 cities, then the risk of fire occurring in all three is nondiversifiable, since you cannot go elsewhere.

B: This is nondiversifiable. If you were an investor, that's what you want here, since risk=returns. In this case, by holding only oil, you are nondiversified and you made a substantial gain.

C: This can be diversifiable. You can avoid the risk of the major lawsuit having an ...

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