Question

You are concerned about one of the assets in your fully diversified portfolio. You just have an uneasy feeling about the CFO, Ian Malcolm, of that particular firm. You do believe, however that the firm makes a good product and that it is appropriately priced by the market. Should you be concerned about the effect on your portfolio if Malcolm embezzles a portion of the firm’s cash? Discuss in light of your readings on diversification of assets in a portfolio.

Further assume your friend Jane is trying to decide to purchase stock from that same company. Jane doesn’t hold a diversified portfolio like you do. Based on the relationship between risk and return, will you be willing to pay a higher price for the stock than Jane? Explain.

Answer 1

CFO embezzling cash is a firm specific risk and can be diversified away by holding well diversified portfolio of random correlated stocks with low correlation. For well diversified portfolios, the relevant measure of risk is beta and not standard deviation. This embezzlement of cash by CFO increases total standard deviation but not beta as firm specific risk is part of standard deviation and not beta or systematic/market risk. Hence, I should not be concerned regarding risk.

For non well diversified portfolios or standalone portfolios, the relevant measure of risk is standard deviation. This firm specific risk is part of standard deviation. This embezzlement of cash by CFO increases risk or standard deviation. Hence, Jane should be concerned regarding the risk.

Regarding, the price to be paid, both would pay the same price as price to be paid would be dependent on beta and not standard deviation.