Capital Asset Pricing Model

CAPM For each of the scenarios below, explain whether or not it represents a diversifiable or undiversifiable risk. Explain your reasoning a. It is announced that a company is under investigation from the federal government for fraudulent accounting practices. This represents a diversifiable risk. This risk is unsystematic and is unique to the company that is under investigation. Hopefully, if this stock was part of a portfolio, the effect of this risk will be relatively small on the overall value of the portfolio.

A major terrorist attack occurs in the U.S. again. A terrorist attack would be an undiversifiable risk. The consequences of the attack would ripple through the entire economy and would influence a large number of assets. This market risk is systematic and can't be eliminated by diversification. c. A large increase in the price of oil. Although this development might affect a range of stocks the risk is diversifiable. This news would definitely affect oil companies and their suppliers and customers.

Yet, companies not in the oil business might not be affected and therefore the risk is unsystematic. By diversifying assets between industries, an investor can mitigate risk. d. The CEO of a major corporation is involved in a sex scandal. This is another example of diversifiable risk. The sex scandal would likely only affect the one company. Overall, this risk would be easily diversified over an entire portfolio. This risk is definitely systematic. 2. Use the CAPM to answer the following questions: a.

Find the Expected Return on the Market Portfolio given that the Expected Return on Asset I is 5%, the Risk-Free Rate is 2%, and the Beta for Asset I is 1.5. E (I) =.02 + [(.05-.02) * 1.5] =.065 = 6.5% b. Find the Risk-Free Rate given that the Expected Return on Asset I is 12.5%, the Expected Return on the Market Portfolio is 7%, and the Beta for Asset I is 2. E (I)=.125 = x + [(.07-x) *2] = R (f) R (f) =.015 = 1.5% c. What will happen to the Beta of a diversified stock portfolio as more stocks are added to it? Explain your reasoning.

Adding stock to a portfolio will bring beta closer to 1.00, which is the beta of the market portfolio. Diversification will bring the beta closer to the market beta. 3. In one page or more, explain what you think are both the major drawbacks and advantages of using the CAPM. CAPM is the equation of the SML showing the relationship between expected returns and beta. There are many advantages to using CAPM to assess expected returns.

Any asset should be at the SML and if it is not, then the asset is not properly priced. CAPM has three components. The pure time.