(a) Briefly explain the concept of diversification. In your discussion, you should explain why the standard...

(a) Briefly explain the concept of diversification. In your discussion, you should explain why the standard deviation of a portfolio of two securities can be less than the weighted average of the standard deviations of the individual securities.

(b) Explain the differences between the capital market line and the security market line.

Solutions

Expert Solution

A) The concept of diversification advocates that when there are are higher number of assets which are added into the portfolio that will be leading into elimination of unsystematic risk out of the portfolio and that will be providing the benefits of diversification into the stock portfolio.

diversification will be meaning that when there would be allocation of portfolio into different asset classes for different securities that will be eliminating the risk of company specific in nature so that will be making the portfolio less risky and more return worthy.

it can also be said that diversification will be completely eliminating the unsystematic risk of the portfolio and unsystematic risk will always be having a large significance in the portfolio formation.

Standard deviation of a Portfolio of two securities can be less than the weighted average of standard deviation of individual security because when both the securities are merged together in a Portfolio, then unsystematic risk related to both these securities are eliminated to a higher extent and that would be leading to a lower amount of risk present in the portfolio and due to the lower risk, there would be lower standard deviation because standard deviation is a reflection of the total risk of the portfolio.

B) differences between capital market line and security market line are as follows-

A. standard deviation will be the measure of risk in capital market line where the beta coefficient will be determining the risk factor of security market line.

B. capital market line is the line which will be showing the rate of return which will depend upon risk free rate and security market line is a graphical representation of market risk and return at a given time

C. capital market line is considered to be superior when measuring the risk factors than the security market lines

D.capital market line will be plotting efficient portfolio whereas security market line will be plotting efficient as well as non efficient portfolio

E. Market portfolio and risk free assets are determined by capital market line and all the security assets are determined by security market line.

jeff jeffy answered 1 year ago

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