Question

Please describe the meaning of diversification. How does diversification reduce risk for the investor?

What is the opportunity cost of capital? How can a company measure opportunity cost of capital for a project that is considered to have average risk?

Answer 1

Diversification

Meaning of Diversification

• Diversification is differentiating of your investment into multiple sectors. Without getting stuck and investing in a particular segment you can diversify it in different segments.

For example

Arbitration is one of the best method for diversifying your investment.

• If your investing in particular sector for example Automobile and if the this sectors hits downstream that probably all your stake in this can sector can go for stake. However if you diversifying your portfolio in different segments than probably you can minimise your risk of portfolio.Hence have your portfolio diversified as much that will definitely help your minimise your risk and gain more profit.

Opportunity cost of capital

Opportunity cost of capital is the best alternative to invest in. You can definitely have it calculated through a simple formula shown below :-

ROI ( Return on investment) = Market value of the investment done - the cost/capital required for the investment

So as you mentioned if you need to calculate the opportunity cost of capital for the project your interested in you simply apply the above formula

- You need to calculate capital you required for the project

- Market value of the project

So will have it elaborated below for your understanding with a example on bonds.If the bond is trading at its premium value 105 and is within a year of its maturity and cost of that bond for you is 100. Than opportunity cost of capital for you to invest in that bond would be as below

Market value of bond - 105

Capital you require- 100

Hence you ROI would be

105-100 = 5

Please let me know if you find this answer as required or you need more clarification on this.