Finance

Answer to Essay Question #1:

Idiosyncratic risk is a firm-specific risk that affects the price change of a security. It is also known as unsystematic risk. This risk is unique to the specific security and affects a single asset or small group of assets. In contrast to systematic risk, which is the market risk that affects the larger number of assets. Unsystematic risk of a portfolio can be brought down to zero through diversification whereas systematic risk cannot be diversified. This can be further elaborated with the help of an example. A sudden rise in inflation affects all the companies by lowering the real return of all investments thus creating systematic risk whereas an oil strike by a company affects the specific company or few other companies bur does not affect the world oil market. These are firm specific news creating unsystematic risk. The total risk of any investment is a sum total of both the risk taken together.

The risk premium for idiosyncratic risk is zero. This risk can be diversified and therefore it is not rewarded. Rational investors will not bear this risk hence it is eliminated. Risk premium of a systematic risk can be captured through beta coefficient. Beta measures the volatility of the stock. However, it determines the sensitivity of the stock return to the systematic risk and not the total risk. If beta is 1 then the risk premium of the stock equals that of market. With a greater beta the investors expect a greater risk premium to compensate them for the additional risk taken and vice versa.

Answer to Essay Question #2:

Define the following terms and explain how they affect one another. More specifically, for what purposes are they used and how do they relate to one another: efficient portfolio, individual investor, short selling, Sharpe ratio, beta and CAPM.

Efficient portfolio: It is an optimal portfolio that provides highest return for a given level of risk or lowest risk for a given level of expected return....