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.
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.