Question

1.3. If a stock had no systematic risk, only unsystematic risk, what would be its expected return? Motivate your answer (3)

1.4 Answer this student’s question: “Isn’t it inconsistent to measure risk by the standard deviation in mean variance analysis and by the beta coefficient in the Capital Asset Pricing Model?”(4)

Answer 1

1.3. if the stock did not have any kind of systematic risk and it only has firm-specific risk then, its expected rate of return will only be influenced by the factors of company specific and it will not be reacting to any kind of the market movement and hence the rate of return which will be expected by the investor will be very low because this company will be having a very low kind of risk as they can easily be diversified also, the beta of this company will generally will be LOWER because when there will be no systematic risk and no fluctuation in relation to the market moment then these companies will be not offering with much risk to invest and investor will also not expect higher rate of return from the companies when they are not exposed to the risk, so it can be said that the expected rate of return would be comprehensively lower.

1.4. Yes, it is inconsistent to measure risk, by standard deviation in risk measure in mean variance analysis and beta coefficient in Capital Asset pricing model because standard deviation will always be meaning that there are both kinds of systematic and unsystematic risk with the existing into the economy whereas beta coefficient is only a representation of the systematic risk and Capital Asset pricing model assume that there is no unsystematic risk portfolio and the investor has already diversifed to the firm specific risk and it will mean that it will not be reflecting as a true model because it is just one factor model and hence they will be inconsistent because of the different calculation of the risk.