Capital Asset Pricing Model

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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

Undiversifiable (market )risk:
Market risk is the variability in all risky assets caused by macroeconomic variables. This risk cannot be avoided, regardless of the amount of diversification. Systematic risk (Market risk) factors are those macroeconomic variables that affect the valuation of all risky assets such as variability in the growth of the money supply, interest rate volatility, variability in aggregate industrial production, and natural shocks like drought, earth quake, hurricane, etc.

Diversifiable (unique )risk:
Many of the risks faced by an individual company are peculiar to its activity, its management, etc. These are the unique risks and can be diversified away. Examples of unique risks are a company winning a large contract, wildcat strikes hitting a company, litigation hitting a company or the company facing a governmental investigation.

a. A large fire severely damages three major U.S. cities.

Diversifiable risk
The entire economy will not be affected by a large fire in three major US cities. In fact some companies in cities not affected by fire will benefit as they will meet the demand not being met by companies in the three cities that are affected by the fire.

b. A substantial unexpected rise in the price of oil.

Undiversifiable risk
A substantial unexpected rise in the price of oil will increase the inflation rate that will affect the entire economy and all the companies
c. The bridge on a major highway collapsed and the repairs of the bridge may take up to a year to complete.

Diversifiable risk
The entire economy will not be affected; in fact some companies in areas not...
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