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CAPM, Risk

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) 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

Please see attached file:
"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.

"

a. A large fire severely damages three major U.S. cities.

Diversifiable risk
The entire economy will not be affected by a large fire in three major US cities. In fact some companies in cities that are not affected by the fire will benefit as they will meet the demand not being met by companies in the three cities that are affected by the fire.

b. A substantial unexpected rise in the price of oil.

Undiversifiable risk
A substantial unexpected rise in the price of oil will increase the inflation rate (unexpectedly) that will affect the entire economy and all the companies in the economy.

"c. A major lawsuit is filed against one large publicly traded corporation.
"

Diversifiable risk
The entire economy will not be affected by a major lawsuit is filed against one large publicly traded corporation. In fact some companies in the same industry will benefit.

Note:
Undiversifiable (market )risk:
Businesses ...

Solution Summary

Answers questions on CAPM and risk (undiversifiable, diversifiable).

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