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- 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 large fire severely damages three major U.S. cities
A prudent investor can diversify risks that are unique to a particular city or cities by investing in many cities. A fire that destroys three cities will create an advantage to suppliers in other cities by creating a deficit in supply of some commodities. This is therefore a diversifiable risk. However, an investor must be aware that the US market is very sensitive to any slight change (Damodaran 2002).
- A substantial unexpected rise in the price of oil
Generally, fluctuations in the prices of oil have an effect on the entire economy since they change the liquidity of money in circulation. For instance, unexpected appreciation in the prices of oil can bring about inflationary effects in the entire economy hence it is an undiversifiable risk.
- A major lawsuit is filed against one large publicly traded corporation
A lawsuit against the corporation is unique to that particular organization and will not affect the entire economy. This is therefore a diversifiable risk as the investor can diversify such a risk by investing in several corporations of public and private nature.
- 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 10%, the Risk-Free Rate is 3%, and the Beta (b) for Asset “i” is 1.5.
Ri = Rf + βi (Rm – Rf)
Ri – expected rate of return on the asset (i)
Rf – risk free rate
βi – beta
Rm – market rate of return
Rm = ((Ri – Rf)/ βi) + Rf
= ((0.1 – 0.03)/1.5) + 0.1
- 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.
Rj = Rf + βj (Rm – Rf) Where:
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