Question

Which of the following best measures an asset's risk?

Select one:

a. Expected return

b. The cash return

c. The standard deviation

d. The probability distribution

You are considering buying some stock in Continental Breakfast. Which of the following is an example of nondiversifiable risk?

Select one:

a. Risk resulting from a news release that there are issues with Continental's production

b. Risk resulting from an explosion in a factory owned by Continental

c. Risk resulting from a general decline in the stock market

d. Risk resulting from an impending lawsuit against Continental

You are considering investing in General Motors (GM) Company. Which of the following is an example of diversifiable risk?

Select one:

a. Risk resulting from an expected recession

b. Risk resulting from the possibility of a stock market crash

c. Risk resulting from interest rates decreasing

d. Risk resulting from uncertainty regarding a possible strike against GM

Answer 1

The correct answer for the first part is (c) i.e. Standard Deviation

The risk of any asset can be simply defined as the amount of volatility, i.e. the difference between actual returns and average (expected) returns. This difference can be termed as standard deviation. Thus, as a concluding note we can say that standard deviation can be used to define the expected range of any investment returns.

The correct answer for the second part is (c) i.e. Risk resulting from a general decline in the stock market.

To understand this, we need to essentially differentiate between a diversifiable and non-diversifiable risk. A diversifiable risk is the one which belongs to any particular asset or company and can be avoided if we decide to let go our investment in that particular asset or company whereas a non-diversifiable risk is the one which cannot be avoided at any cost i.e. any new government regulation or outbreak of a pandemic which will be affecting all the firms in the entire market. The risks mentioned in Option (a), (b) and (d) are strictly and specifically related to Continental breakfast which can be avoided i.e. diversifiable risk if we tend to divert out investment from Continental Breakfast. However option (c) i.e. Risk resulting from a general decline in the stock market cannot be avoid and it is a non-diversifiable risk which will impact the entire market.

The correct answer for the third part is (d) i.e. Risk resulting from uncertainty regarding a possible strike against GM

As explained in the second question above, non-diversifiable risk is a risk which cannot be avoided and impacts the stock market or industry at a whole whereas diversifiable risk is a risk which is specific to any single firm and can be avoided if we tend to divert our investment from it or simply don’t investment in that particular firm. In this case the first three options i.e. (a), (b), (c) represents the risks associated with expected recession, stock market crash, decreasing interest rates - all of which are non-diversifiable in nature as they impact the entire market/industry as a whole rather than impacting any specific firm. However if we look at the option (d) Risk resulting from uncertainty regarding a possible strike against GM, it is diversifiable risk as it can be avoided if we don’t invest in GM and invest in any competitors company such as ford (obviously after doing adequate research).