Diversifiable and undiversifiable risk in economic scenarios

Capital Asset Pricing Model (CAPM)

Basically, a diversifiable risk can be taken to be that risk which is largely limited to a given sector or security. On the other hand, a risk which affects the entire assets or liabilities class is referred to as an un-diversifiable risk. While it is possible to eliminate or reduce a diversifiable risk through diversification, the same cannot be utilized when it comes to the elimination or reduction of an un-diversifiable risk.

A Substantial Unexpected Increase in Inflation

This can be classified under un-diversifiable risks. According to Huwawini & Viallet (2010), events that seem to impact on the entire economy are in most cases the sources of un-diversifiable risks. Inflation impacts on an entire economy and is hence an un-diversifiable risk. This risk cannot be minimized through diversifying a portfolio

A Major Recession in the U.S.

A downturn in economic activity is referred to as a recession. A recession is an example of an un-diversifiable risk based on the fact that it cannot be averted through diversification as it impacts on an entire market.

A Major Lawsuit is filed against one Large Publicly Traded Corporation

This is an example of a diversifiable risk. The reasoning here is that a major lawsuit filled against a large publicly traded corporation only affects the security of that particular company. Such a risk has a very minimal impact on a portfolio that is well diversified. A risk of this nature can hence be minimized through diversification.

Question 2

a) In this scenario, I will utilize the CAPM formula. According to Pahl (2009):

KP = KRF + (KM - KRF) * ss where Expected Rate of Return (Asset) has KP as its denotation; Risk-Free Rate has the denotation KRF; Expected Rate of Return (Market Portfolio) has KM as its denotation and finally; Beta is represented by ss.

Substituting for the values, we shall have;

0.12 = 0.04 + (KM - 0.04) * 1.2

0.08 = 1.2 KM -- 0.048

1.2 KM = 0.128

KM = 0.107

b) In this case, the Risk-Free Rate will be derived by substituting presented values in the CAPM formula given by Pahl (2009) as KP = KRF + (KM - KRF) * ss.

Substituting for the values, we shall have;

0.09 = KRF + (0.1 - KRF) * 0.8

0.09 = KRF + 0.08 -- 0.8KRF

0.2KRF = 0.01

KRF (Risk-Free Rate) = 0.05

If I held half of the traded stocks on various major exchanges, the beta of my portfolio would be 0.5. My reasoning here is founded on the fact that beta represents the total risk of making an investment in a market taken to be large where in such a case, it is represented by 1.

CAPM: Message to Corporations

CAPM, as an economic model, seeks to bring out the probable link between returns (expected) and the prevailing risks. The model is especially useful to corporations in that they can invoke it for purposes of cost of capital estimation. In general terms, CAPM demonstrates to corporations that dividend growth model is not effective enough because of its failure to consider the systematic risk level of an entity with the entire stock market as a reference point. Hence in regard to corporations, CAPM seems to state that the relevance of taking into consideration a company's level of un-diversifiable risk with the stock market as a reference point cannot be overstated when it comes to the computation of the cost of equity.

CAPM: Message to Investors

As an investor, no matter how much diversification one does, it is not possible to eliminate all the risks associated with a particular investment or a certain class of investments. In that regard, there is an existing need for a rate of return which enhances the compensation of investors for the risk taken. CAPM comes in handy when it comes to the computation of not only the return expected on a given investment but also the inherent investment risk.