Diversification refers to the strategies of reducing economic risk by investing in assets whose performance is not affected by the same economic variables. A group of assets forms a portfolio. A company can have two types of economic risks; financial risks and total operating risks. Financial risk results from use of debt capital in the companys structure and it is usually measured using the gearing ratio. Gearing ratio is found by dividing total debt capital with equity and then multiplying the quotient with a hundred percent. The higher the gearing ratio the higher the risk The total operating risk is the fluctuation of the company’s expected earnings of portfolio due to the nature of the industry in which the company operates. Total risk is a combination of systematic and unsystematic risk. Systematic risk is the variation in return of securities due to factors which systematically affect all firms adversely such as war, recession and high interest rate. Systematic risks are therefore not diversifiable and the concept of diversification cannot apply to them. Based on this argument then, it is correct to say that a large fire that relentlessly affects three major U.S. cites is a systematic risk and systematic risks are not diversifiable. Unsystematic risk is the variation in return of a company or a security due to factors unique or specific to a particular company or portfolio. These are the factors such as legal suits, winning or losing in a major contract, successful or unsuccessful marketing strategy. Since these events are random, they can be eliminated by diversification where bad events in one firm will be offset by a good event in the other. A significant anticipated increase in oil prices and a major legal suit against a public company are unsystematic risks which can be eliminated by portfolio diversification. Factors affecting the efficiency of a portfolio include the number of securities forming the portfolio and the nature of relationship between return of security forming the portfolio. Research has shown that between twenty and twenty five well selected securities will form an efficient portfolio. The nature of relationship between return of security forming the portfolio can either be positive or negative. Security returns are assumed to have a negative relationship if a given economic factor affects their performance in the opposite direction. Therefore for risk diversification negative relationship is recommended. Capital asset pricing model Given that the return of asset ‘i’ is 10%, the risk free rate is 3% and the Beta (b) for Asset ‘I’ is 1.5 the expected rate of return of the market portfolio is given by: Expected return of market portfolio will be abbreviated as E_Rm Beta for asset ‘I’ will be abbreviated as B_i Risk free rate will be abbreviated as R_f Market return for asset ‘I’ will be abbreviated as R_i E_Rm = R_f + B_i (R_i- R_f ) E_Rm = 3% + 1.5 (10% – 3%) = 13.5 If the expected rate of return on asset ‘j’ is 14%, the Beta of the asset is 1.5 and the expected return on the market portfolio is 12% then by rearranging the CAPM we can find the risk free rate. 12% = R_f + 1.5 (14% -? R?_f ) 21%-12%=1.5 R_f- ? R?_f 0.5 ? R?_f = 9 ? R?_f = 18% The Beta of an entire market portfolio is usually equal to one therefore the Beta of a portfolio containing half of the stocks in the entire market is zero point five (0.5) Message of CAPM to corporate and investors CAPM allows the analyst to split the total risk of security into portions namely diversifiable and non diversifiable risk. It provides a framework for measuring systematic risk of an individual security and relating it to the systematic risk of a well diversified portfolio. CAPM states that the risk that remains after diversification can be measured by the degree to which the given stock tends to move up and down in the market (the sensitivity of the returns to changes in market portfolio). Systematic risk can be measured by Beta factor. To investors and corporate CAPM allows them to identify extent of diversifiable risk in their portfolio and contrasts this risk to an ideal portfolio. CAPM also allows investors and corporate apply the security market line (SML). The tradeoff between market risk and return in a well diversified portfolio is represented by the security market line. This is important for corporate as they strive to achieve optimal market portfolio in order to achieve the best return and attract investors. SML is similar to capital market line (CML) except in the following ways; CML deals with total risk as measured by standard deviation while SML deals with systematic risk as measured by beta factor. The CML deals with efficient portfolios while the SML deals with individual security. Since investors deal with individual securities they can apply SML. Corporations can use CML since they are interested in total risk. The main message of CAPM is therefore; a market portfolio is representative of all the securities in the market, a security with a Beta factor equal to one means all securities in the market are represented in the in the portfolio, a security with a Beta factor more than one is said to be more sensitive and less than one is sad to be less sensitive. The risk free rate is represented by the treasury bills and government bonds rate of return.
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