Question

Explain in a few lines why diversifiable risk cannot be remunerated on markets in equilibrium?

A shareholder requires a rate of return that is twice as high on a share with a β coefficient that is twice as high as an other share. True or false(Explain)

What does a low-risk premium indicates?

Answer 1

Diversifiable risk is the risk which can be easily diversified away, this risk is firm specific risk and is unique to an organisation. So, this risk cannot be remunerated. Only market risk is the risk which cannot be diversified away and so it is remunerated as it uniformly affects all securities.

Beta is the systematic risk of a security. The higher the beta of a security,the higher is the risk and hence the required return of the security will also be high.

So, a security which has twice the beta the investors of the security will demand for a higher (twice) the rate of return.

So , it is true.

Risk premium is the addition compensation the investors receive above the risk free rate for the additional risk in a security compared to a risk free asset.

The higher the exposure to risk , the higher risk premium will be demanded by the investor and lower the risk of a security the investors will be compensated by a lower risk premium.

Low risk premium indicates less exposure to risk in a security.