Question

13

A portfolio beta is a weighted average of the betas of the individual securities which comprise the portfolio. However, the standard deviation is not a weighted average of the standard deviations of the individual securities which comprise the portfolio. Explain why this difference exists.

14

Explain the difference between systematic and unsystematic risk.

17

A stock has an expected return of 11 percent, the risk-free rate is 6.1 percent, and the market risk premium is 4 percent.
Calculate the stock's beta.

Answer 1

13.

Standard deviation measures total risk. The unsystematic portion of the total risk can be eliminated by diversification. Therefore, the total risk of a diversified portfolio is less than the total risk of the component parts. Beta, on the other hand, measures systematic risk, which cannot be eliminated by diversification. Thus, the systematic risk of a portfolio is the summation of the systematic risk of the component parts. Therefore, a portfolio beta is a weighted average of the betas of the individual securities which comprise the portfolio and the standard deviation is not a weighted average of the standard deviations of the individual securities which comprise the portfolio.

14.

Systematic Risk – These are market risks—that is, general perils of investing—that cannot be diversified away. Interest rates, recessions, and wars are examples of systematic risks.

Unsystematic Risk – Also known as "specific risk," this risk relates to individual stocks. In more technical terms, it represents the component of a stock's return that is not correlated with general market moves.

	Systematic risk	Unsystematic risk
Meaning	Refers to the probability of loss linked with the whole market segment such as changes in government policy for the specific industry.	Refers to risks associated with a particular industry like labor strike
Nature	Ocurs due to uncontrollable factors such as natural calamities. Non diversifiableand uncontollable in nature.	Occurs due to controllable factors such as the production of undesirable products.Diversifiable and contollable in nature
Protection	Can be eradicated through several ways like asset allocation or hedging.	Can be eradicated through portfolio diversification.
Affects	Distresses a large number of organizations in the market or an entire industry sector.	Distresses a particular company.
Factors	Occurs due to macroeconomic factors such as social, economic and political factors.	Occurs due to the micro-economic factors such as labor strikes.
Examples	The Great Recession of 2008 proves to be a key example of systematic risk. People who had invested in all kinds of securities saw the values of their investments fall due to the market-wide economic event. The great recession affected various securities in diverse ways. Thus, investors who held stocks were affected in adverse ways as compared to those with wider asset allocations.	a technology corporation might undertake market research and expect a rise in demand for smaller cell phones and digital watches in the coming year. For that, production lines are altered and capital is dedicated toward smaller devices. However, the company realizes in the next year that consumers are more inclined towards bigger phones and watches. Thus, the inventory and machinery obtained by the company later sells at a major loss or remains unsold. This will, in turn, harm the stock prices of the company. Thus, all the other firms in the technology sector might perform well while this company will backtrack due to poor entrepreneurial foresight.

17)

CAPM Formula

​R_a​=R_rf​+β_a​∗(R_m​−R_rf​)

where:

​R_a=Expected return on a security=11%

R_rf​​=Risk-free rate=6.1%

β_a​​=The beta of the security=?

(R_m​−R_rf​)=Market risk premium​ =4%

R_m​=Expected return of the market=6.1%+4%=10.1%

Stock's beta, β_a= (11-6.1)/10.1= 0.485