a)There's a substantial unexpected increase in inflation:
Undiversifiable/Systematic Risk: Since inflation and related increase in it is a macro economic factor and something not related to performance of stock or related companies, the diversiifcation process cannot deal with it and hence effect of inflation will remain in the portfolio construction even if we include all the availble stock in our portfolio.
b) Major Recession in US:
Undiversifiable/Systematic Risk: Just like Inflation, Recession is also an macro economic factor and an investor cannot deal with it. Important to note that an investor is always compensated for bearing systematic risk not unsystematic risk.
c) A major lawsuit is filed against one large publicly traded corporation.:
Diversifiable Risk: Since a major lawsuit filed against one large publicly traded corporation is a firm specific risk it is to be classified under diversifiable risk and can easily be diversified with intelligent diversification process while constructing the portfolio.
a) As per CAPM Model:
E(RAsset)= RFR + Beta(E(rm)- RFR)
12 = 4 + 1.2(E(rm)-4)
[(12-4)/1.2] = E(rm)-4
6.66 = E(rm)-4
6.66 + 4= E(rm)= 10.66%
Thus, Expected Return on Market portfolio will be 10.66%
* RFR= Risk Free Rate
* E(RAsset)= Expected Return on Asset
* E(rm)= Expected Return on Market Portfolio
b) As per CAPM Model:
E(RAsset)= RFR + Beta(E(rm)- RFR)
9= RFR + 0.8(10- RFR)
9= RFR + 8- .80RFR
RFR= 1/.20= 5%
Thus, Risk Free Rate= 5%
c) Beta is an important factor in CAPM model and represents the measurement of asset’s statistical variance, present in the portfolio that cannot be removed through the diversification process , because of the correlation of its returns with the returns of the other assets that are in the portfolio.
If we talk of market portfolio, it by definition have a beta of 1.0 thus any portfolio which includes half of the stocks traded on the major exchanges will replicate Market Portfolio Beta of 1.0 as it will have the same riskiness as of the market portfolio. Thus as an investor diversofy across the portfolio and include more stocks in the portfolio, the risk factor of individual security becomes less important and it approaches the riskiness of the market.
Academic research has proved that we do not need to include all the stocks in the portfolio to achieve maximum diversification portfolio or to achieve beta of 1.0. The research proved that a well diversified portfolio can be constructed with about 30 stocks. Thus, most likely, if the investor hold half of the stock on the exchange, he will be having more than 30 stocks, thus suggesting that beta of this portfolio will be having same risk as of the market and a Beta of 1.0
The Theory of Capital Asset Pricing Model(CAPM) is a revolutionary approach in the arena of Portfolio Management and Security Pricing. However, CAPM model comes with a different purpose for corporations and investors.
The idea behind CAPM Model for an investor is related to as how rationally an investor should be paid. CAPM Model is a representation of time value of money and risk. Where Risk Free Rate represents Time Value of Money and compensates the investor for channelizing their money into the asset class for a period of time. The other half of the CAPM represents the risk and the outcome represents as what an investor should be paid for bearing the risk above risk free investments.
CAPM comes with a different message for Corporations. Whereas for investor the model outcome is related to as what an investor should be paid for taking the risk in the form of investment; for corporations, the model is a representation of Cost of Acquiring Equity. In most of the corporations, CAPM Model is used to calculate cost of equity with the same formula. This provides benchmark for them and they ensure that only those projects are undertaken that provide returns above the cost of equity as calculated by CAPM Model.
O'Connor, M. (2011). Portfolio Management: Part I. In C. Institute, Portfolio Management (pp. 170-198). Boston: Custom.
O'Connor, M. (2011). Portfolio Management: Part II. In C. Institute, Portfolio Managment (pp. 200-231). Boston: Custom.