Question

Question 1) Answer the following

1a) Which Connection does the diversification effect have to the CAPM?

1b) What is the common Risk measure in Finance? What are the shortfalls of this measure?

1c) What are the Connections between the findings in Portfolio Theory and 1) Investment / 2) Financing decisions?

Thanks so much in Advance.

Answer 1

1a) Diversification effect eliminate unsystematic risk in the CAPM which take into account Beta (calculation for systematic risk).

1b) Common risk measure in Finance are standard deviation and Beta.Standard deviation indicates how much the current return is deviating from its expected historical normal returns. whereas Beta measures the amount of systematic risk an individual security or an industrial sector has relative to the whole stock market.

Shortfalls of Beta is that stocks should be liquid i.e. traded frequently. It measure volatility of stock return with market return It can be useful for measuring short-term volatility.

Shortfalls of Standard Deviation is inappropriate measure of dispersion for skewed data.

Portfolio theories used assumptions in their workings however investment or financing decision does not.