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. There’s a substantial unexpected increase in inflation. There’s a major recession in the U.S. A major lawsuit is filed against one large publicly traded corporation. Use the CAPM to answer the following questions: 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. 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. 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. 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? Assignment Expectations The Case report should be a two-page report. Please show your work for quantitative questions.

 

Capital Asset Pricing Model

 

Diversifiable risk commonly known as unsystematic risk entails the risks that affects a particular security or industry.  The risk can be reduced by the investor diversifying his investments portfolio in different stocks and different industries. Undiversifiable risks can also be termed as systematic risks which affect the whole market without effects on a particular industry or stock. Systematic risk is hard to predict when it will occur and also cannot be avoided completely though it can be mitigated. Mitigation is by diversification of using the right strategy to allocate assets. (Ewens, 2013)

1. Increase in inflation is an undiversifiable risk because it entails the increase in prices of the entire market. This is because the entire economy is affected by the high inflation. Inflation reduces the value of money in terms of purchase hence making securities unaffordable for investors.   
2. Major recession in the United States is an undiversifiable risk as recession indicates the decline of the economy for about half a year. The whole economy is affected which shows that entire security market will be affected by the decline. Recession is hard to avoid and investors have to bear and wait for the period to end.
3. A lawsuit against a large public traded corporation is viewed as a diversifiable risk because it affects the specific corporation. The lawsuit does not engage other corporations of the market at large. 

Expected rate of Return = R f + beta (R m – R f)

                                               0.04 + 1.2 (0.12) = 1.8%

E (R i) = 1.8%

Risk free Rate of Return = E s – B s (Rm- R f)

1. 1. + 0.9(8) = 17.2 %

R f= 17.2%

The portfolio would have a beta of 1 owning same risks as those of the market. This is due to ownership of half of the stock. Diversifying of the profile makes individual stock less significant and the portfolio risk gets close to the market risk. A diversified portfolio holds the same risk as the market (Amihud, 2002).  

CAPM message to corporations

Capital Asset Pricing Model entails the calculation of investment risks and the expected return from various investments. CAPM determines securities and their prices in regard to the current value of money. Corporation use the model to estimate the cost related to equity financing. These costs are important in determining the WACC. The corporation stands a better chance of attraction potential investors through illustration of required return by CAMP.

CAPM passes information regarding the expected return and it relation to the systematic risk instead of the standard deviation or the total risk of the investment. The corporations get the information from the beta coefficient that indicates risks associated to certain securities and compares them with the whole security market. 

 

Message to investors

CAMP addresses investors on the expected return from the securities they invest and thus having the ability to make decision concerning profitable stock. Investors are also advised on risks associated with various securities. With this the investors evaluates the securities that face minimum risk to make decisions. In cases of unique risks, they should not expect more profit from their investment. The model advises them to invest in markets that are riskier to receive more profits as it is hard to diversify the risky markets.

CAMP advocates for diversification by investors to reduce the occurrence of the unique risks. Also, an illustration of the relationship between the beta and expected return is shown by CAMP. Using CAMP investors are provided with a better discount rate to help them in investment appraisal rather than the use of weighted average cost of capital (WACC). Also, CAMP presents the market efficiency to the investor for all to receive uniform information (Fama, 2004)

References

Amihud, Y. (2002). Illiquidity and stock returns: cross-section and time-series effects. Journal of financial markets, 5(1), 31-56.

Ewens, M., Jones, C. M., & Rhodes-Kropf, M. (2013). The price of diversifiable risk in venture capital and private equity. Review of Financial Studies, 26(8), 1854-1889.

Fama, E. F., & French, K. R. (2004). The capital asset pricing model: Theory and evidence. The Journal of Economic Perspectives, 18(3), 25-46.