Question

1. The following examples of firm-specific or market risk? a. An oil company failing to find oil in one of its oil fields. b. GDP numbers beating expectations. c. The SEC finding accounting irregularities with a company.

1a. Why isn’t a portfolio’s standard deviation the same as its components?

1b .How might a drop in the price of oil cause both firm-specific and market risk effects?

2,  We have $25 thousand invested in ABC stock (beta=1.5), $50 thousand in DEF stock (beta=0.7), and $15 thousand in GHI stock (beta=1.2). What is the portfolio’s beta?

2a. Long term gov’t bonds are returning 4%. The equity risk premium is 5%. If XYZ stock has a beta of 0.6, what is its expected return?

Answer 1

1.

Note-Firm sepcific risk is also known as the Unsystematic risk. It is purely depends upon the attributed of the Firm.Investor can avoid these types of risk by diversifying his investment and by Complete study of the individual firm.

Market risk is also called as Systematic risk or Explained risk. These risk occurs due to the Marco Economic facors and affects amny firms. Investor can avoid these risk By hedging method.

a. An oil company failing to find oil in one of its oil fields.	Firm-specific Risk
b. GDP numbers beating expectations	Market risk
c.c. The SEC finding accounting irregularities with a company.	Firm-specific Risk

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1(a)

A portfolio compatins various Components of assets and the standard deviation or risk of every component is not same. While calculating the portfolio standrad deviation we take into account various fators like, weight of each component, Coefficient of correlation amont the compoments etc.

The more the diversification among the components , the less will be the standard deviation of the portfolio or vice versa.

Hence the portfolio's standard deviation is not same as its Components.

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1(b)

If the oil price drops in a specific area , then it will be firm specific risk for the Firms situated in those area.

If the Oil price drop in the whole market then it will be a Market risk.

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(2)

Beta of the portfolio = Weighted average of the Individual asset beta or .

		A	B	A*B
Stock	Investment	Weight	Beta	Weight*Beta
ABC stock	25000	0.2778 [25000/90000]	1.5	0.4167
DEF stock	50000	0.5556 [50000/90000]	0.7	0.3889
GHI stock	15000	0.1667 [15000/90000]	1.2	0.2000
Total	90000	1.0000		1.0056

Hence Beta of the Portfolio = 1.0056.

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(3)

As per CAPM or capital asset pricing method,-

Expected return on stock =Risk free return+ Beta*Equity risk premium

=>Expected return on XYZ stock=4%+0.6*5% = 7%