Principles of finance
Undiversifiable risk is also known as known as systematic risk. This is a risk, which is common to all securities, for example the market risk. However, diversifiable risk is also known as unsystematic or idiosyncratic risk. This is the risk associated with individual assets or certain sector of economy or a specific company. A major lawsuit against one large corporation is a diversifiable risk because its effects will be felt in that corporation only and not the entire economy or market (French, 2003).
A substantial rise in oil prices is an undiversifiable risk because oil affects all sectors of economy in that oil is essential in almost all sectors of economy all over the world. A fire severely damaging three major US cities is undiversifiable risk because most of the industries and companies operations are located in those cities; hence most assets of the companies will be affected (Strong, 2008).
Capital asset pricing model (CAPM) is used to determine an appropriate required rate of return of an asset. The model is sensitive to the non-diversifiable risk (market or systematic risk) represented beta (β) as well as the expected return of a risk free asset and the expected returns in the market. CAPM stresses on investing in different assets of different industries from different sectors of the economy to reduce risks involved by investing in a single asset (Strong, 2008).
The formulae of calculating CAPM: E (Ri) = Rf + βi (Rm-Rf)
E (Ri) is the expected return on the asset.
Rf is the risk free rate, for example the government rate on bonds or treasury bills.
(Rm) is the expected return in the market.
βi is the called beta (sensitivity of the expected extra asset return (Strong, 2008).
(a) E (Ri) = Rf + βi (Rm-Rf)
= 3% + 1.5 (10-3)
(b) E (Ri) = Rf + βi (Rm-Rf)
14 = Rf + 1.5 (12- Rf)
14 = Rf + 18 – 1.5Rf
14 – 18 = Rf – 1.5 Rf
-4 = -0.5Rf
Rf = 40/5
Rf = 8%
If I own half of all the stocks traded on the major stock exchange, I expect the beta to increase because I will be expecting a higher a higher rate of returns from my stocks. The beta should also increase because of the high risks associated incase I loose my stocks (Strong, 2008).
CAPM is important to corporation for their success. Investors will use this model to determine the returns in their asset and portfolios by factoring in all the components in determining the expected returns (French, 2003). It helps to understand the importance of investing in different assets called portfolio to spread risks in different sectors, industries, or corporations in the economy. If there is an investment that is risk free or have its riskness is low, the corporation or individual investors can make decision on whether to invest or not. CAPM is important in to investors in pricing the asset and in making decisions on which stocks to buy and which ones to dispose off (French, 2003).
In any investment, there are uncertainties involved; hence, the net present value can be calculated and to correct any deviations that may arise after the investment has commenced (Strong, 2008). CAPM gives a guide to the rational investors that they should not rush at any investment, which may be prone to diversifiable risks but should consider the non-diversifiable risks because they are rewarded within the scope of the model. Though returns on every asset are important, it should be linked to the riskiness of the portfolio not an individual asset. The beta in the portfolio is the most important component to be considered because it rewards the systematic risks and exposures taken by the investor (French, 2003).
In conclusion, the main message to the investors contained in the CAPM is having a diversified portfolio. Portfolio is the collection or combination of different assets or investments. This means that, investors should not only invest in one asset because, incase of a risk occurring, the investor will loose everything. Different investments are affected by different risks; hence, it is essential to consider the risk rates, beta, and expected returns before making a decision to invest (French, 2003).
French, C. W. (2003). The Treynor Capital Asset Pricing Model. Pittsburg: Pittsburg Press.
Strong, R. A. (2008). Portfolio Construction, Management, and Protection. New York: Cengage