Question

1. difference between systematic and unsystematic risk?

2. how does diversification reduce unsystematic risk?

3. what does CAPM mean?

4. how risk free asset can influence portfolio expected risk and return perspective?

5. why does the investment theory talk about optimal portfolio?

Answer 1

Q: Difference between Systematic Risk and Unsystematic Risk;

Ans:

Risk is an inherent concept to be considered in every investment. Two major components of risk are systematic risk and unsystematic risk. Systematic risk is a result of external and uncontrollable factors. These might not industry or sector or security specific and it can affect the entire market leading to the fluctuation in prices of all the assets / businesses / securities / investements.

On the other hand, Unsystematic risk refers to the risk which emerges out of controlled and known variables that are industry or sector or security specific.

Systematic risk cannot be eliminated by diversification of portfolio, multi businesses / sectors, whereas the diversification proves helpful in avoiding unsystematic risk.

Examples of risk that might be specific to individual companies or industries are business risk, financing risk, credit risk, product risk, legal risk, liquidity risk, political risk, operational risk, Global factors etc. Unsystematic risks are considered governable by the Company or industry.

Factors for Comparison	Systematic Risk	Unsystematic Risk
Meaning	Risk associated with the market or market segment as a whole.	Risk associated with a particular security, company or industry.
Nature	Uncontrollable	Controllable
Factors	External factors	Internal factors
Affects	Large no. of companies, industries, investments, countries, etc	Only particular company / investment
Types	Interest risk, market risk and purchasing power risk	Business risk and financial risk
Protection	Asset allocation	Portfolio diversification

Q: How does diversification reduce unsystematic risk?

Ans:

Diversification can greatly mitigate the impact of unsystematic risk. It is unlikely that all events under unsystematic risk would happen in every firm / investment at the same time. Therefore, by diversifying the risk can be mitigated.

Diversification reduces risk by allocating investments among various financial instruments, industries, and other categories. It targets to maximize returns by investing in different areas that would each react differently to the same event. There shall be chances that the risk from one investment can be subsidised thru potential high return from the other investment.

Q: what does CAPM mean?

Capital Asset Pricing Model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio. This tool is generally used in Stocks/securities; It is used to calculate the predicted rate of return of any risky asset. It compares the relationship between systematic risk and expected return. This model is important for the investors as it gives a perspective on the required return for an investment on a financial asset;

Formula for calculating the expected return of an asset given its risk is as follows:

ERi​=Rf​+βi​(ERm​−Rf​)

Where:

ERi​=expected return of investment

Rf​=risk-free rate

βi​=beta of the investment (Beta is a measure of the volatility, or systematic risk, of a security or portfolio, in comparison to the market as a whole)

(ERm​−Rf​)=market risk premium​

Q: how risk free asset can influence portfolio expected risk and return perspective?

Ans:

The risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. This acts as a inversely proportional to the risk / return factors; Incase of portfolio affecting with the various risk factors, these assets shall subsidise the overall risk impact by contributing their share of risk free return to the overall portfolio; Incase of the portfolio generating higher returns, the investments in these risk free assets drag down the overall return of the portfolio;

Q: why does the investment theory talk about optimal portfolio?

In the environment of Investments, Optimisation of the portfolio is a continuous process.

Optimal portfolio is a term used in portfolio theory to refer to the one portfolio on the Efficient Frontier with the highest return-to-risk combination given the specific investor's tolerance for risk.

This benchmark theory called Efficient Frontier was introduced by Nobel Laureate Harry Markowitz in 1952.

- Effective frontier comprises investment portfolios that offer the highest expected return for a given level of risk.

- Returns are dependent on the investment combinations that make up the portfolio.

- Successful optimization of the return versus risk proposition matches a portfolio with the efficient frontier line.

- Optimal portfolios that comprise the efficient frontier tend to have a higher degree of diversification. This establishes the fact that the diversification of portfolio / assets is very important for the optimisation.