Question

2. What is a diversified portfolio? What type of risk is reduced through diversification? How many securities are necessary to achieve this reduction is risk? What characteristics must these securities are necessary to achieve this reduction in risk ?what characteristics must these securities possess ?   

7.what is beta coefficient ? what do beta coefficient of 0.5 ,1.0 and 1.5 mean ?

8. If the correlation coefficient for a stock and the market equals 0 , what is the market risk associated with the stock?

9. How are the capital market line and the security market line different? What does each represent ?

10. How does arbitrage pricing theory advance our understanding of security returns?

Answer 1

2. A diversified portfolio is a portfolio which has a combination of assets which reduces the systematic risk in the portfolio. Systematic risk is reduced in the portfolio. A diversified portfolio consists of assets from all or different sectors of the economy. Holding assets from just one sector will not result in risk reduction,but holding assets from a variety of sectors a d industries leads o risk reduction with the help of diversification.

There is no limit on the amount of securities needed to achieve diversification benefits. The characteristics necessary for these securities to possess is that , there should be low correlation between the assets in a diversified portfolio.

7. The beta coefficient measures the sensitivity of the stock to the movements of the overall market. If the beta co-efficient is less than one, for example Beta coefficient is 0.5. If the market moves by 1%, the stock moves by 0.5%. The sensitivity of the stock is less than the market movements.

If the beta-coefficient is 1.5, the market moves by 1%, then the stock moves by 1.5%. The stock is more volatile than the market.

8. Market risk also called beta = Covariance of stock returns with the market / variance of the market.

Now, if the correlation coefficient for a stock with the market is zero, the beta that is the market risk will be zero.

The zero value depicts that there is no relation between the stock and the market . For example, the markets may rise and fall but it will not affect the stock at all.

9. The capital market line shows the return and risk of a specified asset whereas the security market line shows the return and risk of individual assets. CML is used for a portfolio of assets whereas SML is used for individual assets as well as portfolios.

The capital market line (CML) represents portfolios that optimally combine risk and return. The security market line (SML) is a line drawn on a chart that serves as a graphical representation of the capital asset pricing model (CAPM).