Words: 1228
School Name: TUI University Name: Kevin D. Cruise The Course Dept#: Principles of Finance – FIN 301 Module 3 Case Assignment Professor’s Name: Dr. John Halstead Assignment: 1. For each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning a. A large fire severely damages three major U. S. cities. b. A substantial unexpected rise in the price of oil. c. A major lawsuit is filed against one large publicly traded corporation. . Use the CAPM to answer the following questions: a. Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset “i” is 10%, the Risk-Free Rate is 3%, and the Beta (b) for Asset “i” is 1. 5. b. Find the Risk-Free Rate given that the Expected Rate of Return on Asset “j” is 14%, the Expected Return on the Market Portfolio is 12%, and the Beta (b) for Asset “j” is 1. 5. c. What do you think the Beta (? ) of your portfolio would be if you owned half of all the stocks traded on the major exchanges? Explain. . In one page explain what you think is the main ‘message’ of the Capital Asset Pricing Model to corporations and what is the main message of the CAPM to investors? Assignment Expectations: The Case report should be a two-page report. Please show your work for quantitative questions. 1. For each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning a. A large fire severely damages three major U. S. cities.
In this scenario it can be defined as an undiversifiable risk. The companies in these three major U. S. cities are basically victims of circumstance. Let’s take a look at Katrina when it hit Louisiana and Mississippi. While it didn’t affect the whole stock market, it did have a huge impact the economic situation for Louisiana. A large fire would have the same effect as Katrina did. The loss of schools, jobs, homes and businesses was devastating to say the least. Louisiana while they have recovered some over the last 5 years, there is still more recovery that needs to be done.
When you have a situation like this you have to remember that it just isn’t affecting a small number of people but thousands possibly millions. Hundreds of people lost their lively hood and had to relocate to new areas and start all over again. For the economic situation of these three major cities, infrastructures have been ruined and have to be rebuilt which takes money and time. The federal government usually has to come to the aid of those cities or states that are effected by this disaster. b. A substantial unexpected rise in the price of oil.
Well, we all know firsthand what will happen when we have an unexpected rise in the price of oil. This caused a major economic crisis that we still haven’t recovered from. We lost major automotive companies that have been around for decades because we did not forsee this or weren’t prepared for such an incident. The sudden rise in the price of oil has caused the whole world to relook the automotive industry and we are scrambling to develop alternative motives of fuel sources for our cars. Actually, this is an issue that was brought up 30 years ago but never fully addressed because of greed.
We knew that we would run into a situation that could cause us to run low on crude oil which would drive the price up. While some companies were developing alternative sources of energy or fuel to propel our car, it was never really taken serious because we just chose to overlook the issue and continued to build bigger cars. Now, we are faced with a situation which has global repercussions. This is an undiversifiable risk for certain. c. A major lawsuit is filed against one large publicly traded corporation. For this scenario, this would probably be a diversified risk because it is only affecting one sector.
It would be bad for that company that has the lawsuit filed against them while their rival may strive or prosper from their downfall. One such company was Enron. Their stockholders took a beating and lost millions of dollars in the process. It had a huge impact on the stock market because of the type of business it was. However, if your portfolio was diversified then you only lost out on that one stock. 2. Use the CAPM to answer the following questions: a. Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset “i” is 10%, the Risk-Free Rate is 3%, and the Beta (b) for Asset “i” is 1. . 3 + 1. 5(10 -3) = 3+ 1. 5(7) = 3+ 10. 5 = 13. 5% b. Find the Risk-Free Rate given that the Expected Rate of Return on Asset “j” is 14%, the Expected Return on the Market Portfolio is 12%, and the Beta (b) for Asset “j” is 1. 5. (1. 5 * 14)/ 12= 8% c. What do you think the Beta (? ) of your portfolio would be if you owned half of all the stocks traded on the major exchanges? Explain. If I owned half of all the stocks traded, my beta would probably be less than because with a Beta value higher than 1 would cause my stocks to be riskier and would have a greater chance to outperform the market.
The more money that I pay for a stock the more the more money I have a chance to earn but it isn’t guaranteed. 3. In one page explain what you think is the main ‘message’ of the Capital Asset Pricing Model to corporations and what is the main message of the CAPM to investors? For corporations basically the CAPM is saying to them that they have to show investors what makes their company reputable and worth a high stock value. The Beta for corporations basically classifies it as a volatile or non volatile stock.
The number of investors or other companies that invest in your corporation says that they believe in your company and what they stand for. The sales is what brings all of that together. The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk.
This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf). Investopedia. com. When investing in a company stock you want to look at their earning over the last year or two. Also, look at the number of employees, their sales, outstanding stocks and potential for earning. The more stocks that I purchase means that I think that I have a good chance of earning a lot of money if their stocks goes up in a few months or years depending on how long I am looking to invest in this corporation.