Question

In: Finance

Which of the following types of risk cannot be eliminated by holding a well-diversified portfolio of...

Which of the following types of risk cannot be eliminated by holding a well-diversified portfolio of investments?

A Diversifiable risk
B Market risk
C Portfolio risk
D Answers a. and b. are correct.
E Answers b. and c. are correct.

Solutions

Expert Solution

The Correct Answer would be E - Answers B. and C. are correct.

Market Risk and Portfolio Risk cannot be eliminated by holding a well-diversified portfolio of Investments

The Capital Asset Pricing Model (CAPM) is an equilibrium model of asset prices in a risky market.

The Capital Asset Pricing Model (CAPM) states that Risk can be decomposed into Systematic and Unsystematic Risk. Unsystematic risk is diversifiable so the only relevant risk is the Systematic Risk captured by Beta.

Systematic risk or Market Risk : This risk cannot be avoided through diversification as it is inherent risk to the market. These risks arise to factors that affect the overall market such as changes in the national economy, tax reform by government etc. This is the risk which is common to an entire class of assets or liabilities. These risks cannot be diversified as it affects the securities overall.

Since Cash flows are risky the required rate of return is Risk Adjusted Return. As per the assumptions of CAPM, the only relevant measure of risk is Systematic Risk, The Systematic Risk of a stock refers to sensitivity of the stock to the economy. Economy is captured by Market Portfolio and Systematic risk is measured in terms of Beta i.e. Sensitivity with respect to market.

Portfolio Risk is the sum total of Systematic Risk or Market Risk and Unsystematic Risk or Diversifiable Risk. As Portfolio risk contains Systematic Risk it cannot be eliminated by holding a well-diversified portfolio of Investments.

Unsystematic risk or Diversifiable Risk : This risk can be avoided through diversification. The greater the number of stocks in our portfolio, the greater will be the chance of Unsystematic risk to be cancelled out. This type of risk is unique to a particular company or industry. This is the risk of price change due to unique circumstances of a specific security as opposed to the overall market. This risk can be virtually eliminated through diversification.

Therefore it can be concluded that Market Risk and Portfolio Risk cannot be eliminated by holding a well-diversified portfolio of Investments but Diversifiable risk can be eliminated by hoding a well-diversified portfolio of Investments


Related Solutions

For diversified portfolios, which of the following is (are) false? a. the risk of a portfolio...
For diversified portfolios, which of the following is (are) false? a. the risk of a portfolio is less than the weighted average risk of the individual assets in the portfolio if the correlation coefficient is less than one. b. stock held in isolation is more risky than a stock held in a portfolio c. relevant risk of a stock is its contribution of risk to a portfolio d. the unique risk of a portfolio increases as more companies are added...
Which of the following types of risk is the least important risk for a diversified investor?...
Which of the following types of risk is the least important risk for a diversified investor? A:) systematic risk B:) Undiversifiable risk C:) market risk D:) idiosyncratic risk  
Well-diversified portfolio A has a beta of 1.0 and an expected return of 12%. Well-diversified portfolio...
Well-diversified portfolio A has a beta of 1.0 and an expected return of 12%. Well-diversified portfolio B has a beta of 0.75 and an expected return of 9%. The risk-free rate is 4%. a. Assuming that portfolio A is correctly priced (has ?? = 0), what should the expected return on portfolio B be in equilibrium? b. Explain the arbitrage opportunity that exists and explain how an investor can take advantage of it. Give specific details about what to buy...
Unsystematic risk: Multiple Choice -is measured by beta. -can be effectively eliminated through portfolio diversification. -cannot...
Unsystematic risk: Multiple Choice -is measured by beta. -can be effectively eliminated through portfolio diversification. -cannot be avoided if you wish to participate in the financial markets. -is compensated for by the risk premium. -is related to the overall economy
If you are a diversified investor in Facebook, which of the following types of risk would...
If you are a diversified investor in Facebook, which of the following types of risk would you include in your discount rate? A. The risk that Mark Zuckerberg will stay on as CEO B. The risk that new privacy laws will restrict data gathering and access C. The risk that users will find a different social media platform to spend their time on. D. The risk that a global economic slowdown will affect how much companies spend on advertising E....
Which of the following statements is not true regarding diversification? A well-diversified portfolio should earn the...
Which of the following statements is not true regarding diversification? A well-diversified portfolio should earn the risk-free rate of return A well-diversified portfolio’s risk can be measured by beta A well-diversified portfolio has only market risk A well-diversified portfolio has no unique risk A well-diversified portfolio has stocks whose returns are not perfectly correlated
If holding assets in a diversified portfolio, why is beta, and not standard deviation, the appropriate...
If holding assets in a diversified portfolio, why is beta, and not standard deviation, the appropriate measure of risk for an individual asset?
Systematic Risk is A. eliminated totally if there are over a 30 stocks in your portfolio...
Systematic Risk is A. eliminated totally if there are over a 30 stocks in your portfolio B. the same as unique risk C. the risk from exposure to the market, marcoeconomic factors etc D. the risk arising from the interconnectedness of banks leading to the recession in 2008
Why is it important to invest in a diversified portfolio? Which stock risk measure should you...
Why is it important to invest in a diversified portfolio? Which stock risk measure should you care about if you have a diversified portfolio? Can you eliminate all portfolio risk?
How can I know whether a security portfolio is well diversified/ not completely diversified by looking...
How can I know whether a security portfolio is well diversified/ not completely diversified by looking at its beta, standard deviation, value of treynor ratio and Sharpe ratio?
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT