Question

Q1. The Total Risk of an Individual Share Comprises Both Systematic and Unsystematic Risk. How are these Affected by increasing the Number of Shares in a Portfolio? (approx 200 word)

Q2. Why are Investors Only Focused on Market Risk When Applying the Capital Asset Pricing Model (CAPM)  to Price Risk Securities? (approx 200 word)

Answer 1

Q-1) The total risk of an asset consists of systematic risk and non-systematic risk; systematic risk is the risk which is common across the securities in the market and the non-systematic risk is the risk which is diversifiable, security specific risk. In a portfolio when a large number of securities are added and if the correlation between those securities is less than perfect positive correlation then the risk of the portfolio goes down because of the negative correlation between securities. The reason is because when we add securities in a portfolio with negative correlation then the risk of one of the securities is offset by the movement of return of another security. In CAPM model only risk which matters is systematic risk and it is managed by diversifying stocks in the portfolio. One thing to note here is that if you are increasing the number of stocks of the same security then risk would not be reduced for the portfolio and the maximum benefit of diversification is obtained when the correlation between the securities are perfect negative that is -1 and that is because the movement of risk of one security will be offset by the movement of returns of another security.

Q-2) Market risk is the systematic risk or risk which is common across all securities. The risk in CAPM model is measured by systematic risk and non-systematic risk, systematic risk is the risk which all securities face and mostly common, non-systematic risk is the risk which is security specific or firm specific or industry specific and this risk can be diversified by investing in a stock which has negative correlation with each other so once the non-systematic risk in the portfolio is diversified away then the only the systematic risk remains in the portfolio and in the CAPM model the market risk or systematic risk is the relevant risk. In CAPM model beta is a measure of risk which measures risk in relative to the market so when only systematic risk remains in the market it is natural that investor will be compensated for the systematic risk only. Also one of the major assumptions in the CAPM model is that after diversifying only systematic risk remains in the portfolio so investor should be compensated for that risk only.