ASSIGNMENT #2

1. Examine how portfolio theory assumes investors make investment decisions.

2. Interpret the difference between systemic risk and unsystematic risk;

1. Portfolio theory assumes that investors make investment decisions by considering the
expected returns and risks of different investment options and constructing a diversified portfolio
of assets that maximizes their expected return for a given level of risk. The theory assumes that
investors are rational, risk-averse, and prefer higher returns to lower returns. It also assumes that
investors can access perfect information about the expected returns and risks of different assets
and construct efficient portfolios on the efficient frontier.
The theory suggests that investors can reduce their overall risk by diversifying their
portfolios across different assets that are not perfectly correlated. This means that investors can
reduce the risk of their portfolio without sacrificing expected returns by holding a combination of
assets with different risk levels and returns.

2. Systemic and unsystematic risks are two types that investors face in the financial markets.
Systemic risk refers to the risk that is inherent in the overall financial system and affects all
market participants, such as a global economic recession or a financial crisis that affects multiple
sectors or markets. This type of risk cannot be eliminated through diversification and is beyond
the control of individual investors.
In contrast, unsystematic risk, also known as idiosyncratic risk, refers to the risk specific
to an individual company or asset and unrelated to the overall market or economic conditions.
Examples of unsystematic risk include company-specific events such as a product recall or a
management scandal. This type of risk can be diversified by investing in a portfolio of assets
with different risks and returns.
The critical difference between systemic and unsystematic risk is that the former affects
the overall financial system and cannot be diversified away. At the same time, the latter is
specific to individual assets and can be reduced through diversification. It is vital for investors to
understand the difference between these two types of risk and manage them accordingly in their
investment portfolios.