The capital asset pricing model contends that there is systematic and unsystematic risk for

an individual security. Which is the relevant risk variable and why is it relevant? Why is
the other risk variable not relevant?
The CAPM states the relationship between risk and return. It is an extension of the CML. The
CML stated that the risk of an investor is measured by the total volatility of the investment. The
total volatility of the investment can be calculated only when the investment is a portfolio of
assets. The total volatility cannot be calculated for an individual security. It redefines that the
relevant portion of the risk is not the total volatility of the investment but the non-diversifiable
part of the risk. The risk variable of systematic risk is beta coefficient. Beta is the measure of the
systematic is when compared to the market. The systematic risk is considered as the relevant risk
as it is the actual risk faced by the investor. The other risk is the unsystematic risk and that can be
diversified. The unsystematic risk can be diversified by investing the money in other stocks and
financial instruments. The unsystematic risk is thus, not considered to be relevant as it can be
diversified. Diversification will reduce the risk. If the risk is diversified by the investor then he
will not receive any compensation in the form of return.
Or
BOOK
In a capital asset pricing model (CAPM) world the relevant risk variable is the securitys
systematic risk - its covariance of return with all other risky assets in the market. This risk cannot
be eliminated. The unsystematic risk is not relevant because it can be eliminated through
diversification - for instance, when you hold a large number of securities, the poor management
capability, etc., of some companies will be offset by the above average capability of others.

At a social gathering, you meet the portfolio manager for the trust department of a local
bank. She confides in you that she has been following the recommendations of the
departments six analysts for an extended period and has found that two are superior, two
are average and two are clearly inferior. What would you recommend that she do to run
her portfolio?
The portfolio manager should continue to allow his two superior analysts to make investment
recommendations for some proportion of the portfolio, making sure that their recommendations
are implemented in a way that would conform to the risk preference of the client. They should
also be encouraged to concentrate their efforts in the second tier of stocks, because the second
tier is probably not as efficient as the top tier (because of lower trading volume) and the
possibility of finding a temporarily undervalued security are greater. On the other hand, the
portfolio manager should encourage the average and inferior analysts to direct their efforts to
matching the performance of the aggregate market. As a result, the overall performance of the
portfolio should be superior to the average market performance.
Your 45-year-old uncle is 20 years away from retirement; your 35-year-old older sister is
about 30 years away from retirement. How might their investment policy statements
differ?
The 45-year old uncle and 35-year old sister differ in terms of time horizon. However, each has
some time before retirement (20 versus 30 years). Each should have a substantial proportion of
his/her portfolio invested in equities, with the 35-year old sister possibly having more equity
investments in small firms or international firms (i.e., can tolerate greater portfolio risk). These
investors could also differ in current liquidity needs (such as children, education expenses, etc.),
tax concerns, and/or other unique needs or preferences.
Define liquidity and discuss the factors that contribute to it. Give examples of a liquid asset
and an illiquid asset, and discuss why they are considered liquid and illiquid.
Liquidity is the ability to sell an asset quickly at a price not substantially different from the
current market assuming no new information is available. A share of AT&T is very liquid, while
an antique would be a fairly illiquid asset. A share of AT&T is highly liquid since an investor
could convert it into cash within 1/8 of a point (or less) of the current market price. An antique is

illiquid since it is relatively difficult to find a buyer and then you are uncertain as to what price
the prospective buyer would offer.
Explain why you would change your nominal required rate of return if you expected the
rate of inflation to go from 0 (no inflation) to 4 percent. Give an example of what would
happen if you did not change your required rate of return under these conditions.
If a markets real RFR is, say, 3 percent, the investor will require a 3 percent return on an
investment since this will compensate him for deferring consumption. However, if the inflation
rate is 4 percent, the investor would be worse off in real terms if he invests at a rate of return of 4
percent - e.g., you would receive $103, but the cost of $100 worth of goods at the beginning of
the year would be $104 at the end of the year, which means you could consume less real goods.
Thus, for an investment to be desirable, it should have a return of 7.12 percent [(1.03 x 1.04) - 1],
or an approximate return of 7 percent (3% + 4%).
Discuss why you would expect a difference in the correlation of returns between securities
from the United States and from alternative countries (for example, Japan, Canada, South
Africa).
There are different correlations of returns between securities from the U.S. and alternate
countries because there are substantial differences in the economies of the various countries (at a
given time) in terms of inflation, international trade, monetary and fiscal policies and economic
growth.