Question

1. Explain the difference between unique risk and market risk

2. Explain what diversification is; can you diversify unique risk, market risk, or both?

3. Is standard deviation a measure of total or relative risk?

4. The capital asset pricing model has a parameter called beta, explain what beta measures.

5. Is it true that higher asset volatility should imply higher returns?

6. The S&P 500 is a very diversified portfolio, if diversification helps lower risk, why is it that it fell by around 40% during the economic crisis that began in 2007?

7. What is the difference between ROIC and WACC?

Answer 1

Questions 1:

Systematic Risk/Non-diversifiable risk/Market risk:
1. Risk related to the economy.
2. Cannot be killed by diversification.

For Example:
1. Suppose a war is declared between two countries.
2. Government decisions / New political party coming into power.
3. Interest rate, Inflation fluctuation risk.

Idiosyncratic risk/ unsystematic risk/ diversifiable risk/ firm risk/ residual risk/UNIQUE RISK:
1. Risk arising from firms internal factors.
2. Can be killed by diversification.

Ex:
1. Losses caused by Labour strike/ Trade union.
2. Losses caused by fire breakout.
3. Losses caused by huge R&D failure.

Questions2:
Diversification means a reduction in the overall risk of the portfolio when 2 or more stocks are present in the portfolio. The overall risk of the portfolio is less than its weighted average risk of Individual stocks in the portfolio.

how can an investor have a diversified portfolio?

As per modern portfolio theory. There is a Benefit of diversification of risk when non-perfectly correlated stocks are added in the portfolio.

The benefit of diversification is when non perfectly correlated stocks are added then if the stock return of stock falls then it's offset by a rise in the stock return of another stock.

You can diversify unique risk.
You cannot diversify market risk.

Questions 3:
Standard deviation measures the total risk of a stock/portfolio.

Questions 4:
Capital Asset pricing model:

As per CAPM model:
Re= Rf+(Rm-Rf)B

Re= required rate of return.
Rf= Risk-free rate.
Rm =Market Risk Premium.
B = Beta, systematic risk.

The slope of the regression line is called Beta. The regression line between stock return and market returns.

"Beta measures systematic risk."

It is determined by: Rate of change of stock return to the rate of change of market return. It is the sensitivity of stock return to Market return.