Question

1. “These days in particular, international stocks are too volatile to hold in a diversified portfolio.” Discuss.

2. You work for a publicly traded company that is considering a bid for another firm. As part of this work, you have been tasked with valuing this ‘target’ firm. The target firm is closely held by a single family; the firm is the only valuable asset that the family holds. What is the role of idiosyncratic risk in preparing an initial bid for the target firm?

3. True, False or Uncertain (Justify your answer). An economic downturn may cause many firms to ‘streamline’ their production activities, focusing on a single product line. In those circumstances, the CAPM is less useful than it would be otherwise, when firms have more diversified lines of business.

4. True, False or Uncertain (Justify your answer). I have the opportunity to hold an equally-weighted portfolio of 10,000 investment projects which are uncorrelated with each other, or the economy. The investment projects are extremely volatile. In equilibrium, I should expect to earn approximately the risk-free rate.

Answer 1

1. “These days in particular, international stocks are too volatile to hold in a diversified portfolio.” High volatility of stocks means more risk associated with that particular stock. If the prices goes very high it will gain to the investor and if prices are too low it will make a loss to the investor. These days market out of US is highly volatile to hold in diversified portfolio. Diversified Portfolio means where risk is diversified by investing if different stock and bonds with low or no correlation between them so that if one stock is at loss, investor can gain from other stocks.Therefore, investor being risk-averse don't want to hold the high volatile international stock as he wants to gain maximum at the predetermined risk.

2. Idiosyncratic risk is the risk that is associated with a particular stock and has no correlation with the market risk. Idiosyncratic risk can be reduced by diversification. According to above case, I am valuing the target firm which is closely held by a sing;e family. 'Target' firms are generally risky by nature and therefore we measure the target firm's riskiness by idiosyncratic volatility. Target firms are less attractive to bidders due to lower accounting returns. Thus to make it appealing to bidders, Idiosyncratic risk measurement technique is use which measures the variation from central variable in merger outcomes.

3.False.

An economic downturn may cause many firms to ‘streamline’ their production activities, focusing on a single product line. In those circumstances, the CAPM is equally useful as it was before as it determines the expected return on the security in relation to the market return. As it considers beta as a measurement of risk, therefore any kind of volatility irrespective of the economic downturn will be reflected through Capital Asset Pricing Model (CAPM).

4. Uncertain

I have the opportunity to hold an equally-weighted portfolio of 10,000 investment projects which are uncorrelated with each other, or the economy. The investment projects are extremely volatile. In equilibrium, I should expect to earn approximately the risk-free rate.

The above statement is uncertain as I am holding portfolio which are uncorrelated with each other, or the economy. Therefore, we are uncertain about the return as investment projects are extremely volatile.