Fin 301 Case 3: Diversifiable & Non Diversifiable Risks

FIN 301 Case 3
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FIN 301 Case 3
Q1. Diversifiable risk is associated with asset’s risk that can be caused by random aspects that could be eliminated through diversification. On the contrary, undiversifiable risk is caused by factors that are common to an entire industry or market, therefore diversification cannot eliminate the risk CITATION Nar10 \l 1033 (Nariman, 2010).
* Inflation is undiversifiable risk since it affects the entire market not just a segment of the industry.
* Recession implies that the economy is experiencing an economic decline, which affects everyone. Therefore, this is undiversifiable risk since it is beyond the control of an investor.
* The lawsuit affects one particular firm therefore, is attributable to particular assets. This implies that the risk is diversifiable since other companies or industries are not facing a lawsuit. An investor can purchase stock with other companies to minimize risk.
Q2a)
Expected rate of return on assets (i) = 12%
Risk-Free rate =4%
Beta=1.2
Expected rate of return on the market portfolio;
E (Ri) = Rf+ [E (RM)-Rf] *bi
0.12= 0.04+ [E (RM)-0.04] (1.2)
0.12-0.04+0.048=E (RM) 1.2
0.128=E (RM) 1.2
Expected rate of return on the market portfolio = 0.1067 or 10.67%
b) Expected rate of return on asset = 9%
Expected rate of return on the market portfolio= 10%
Beta= 0.8
Risk free rate =
E (Ri) = Rf+ [E (RM)-Rf] *bi