a) Should small or high-growth firms have higher betas than larger and more mature firms? Discuss....

a) Should small or high-growth firms have higher betas than larger and more mature firms? Discuss. Due to the distinctive nature of unsystematic risk, it can be reduced or eliminated through diversification. Do you agree with this statement? Explain.

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Answer to Question 1)

Small firms shall not have the advantage of economies of scale as compared to the larger firms. Also, they shall not have the ability to withstand the severe macro economic implications; Hence, these firms shall carry higher risk interms of their capabilities and operational sustainability. Similarly, high-growth firms generally have aggressive approach, interms of expanding their operations, expanding to different geographies, etc. In this aspect, they shall be more prone to various risks and instabilities. While the growth-oriented firms go with the ideology of calculated risks, the exposure to certain severe risks shall be more evident.

Answer to Question 2)

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 / investments.

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.

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.

jeff jeffy answered 1 year ago

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