FIN301IA3 - Running Head: The Capital Asset Pricing Model...

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Running Head: The Capital Asset Pricing Model The Capital Asset Pricing Model Maurice A. Tillman Trident University International FIN301 - Principles of Finance Dr. Ludovick Leon Shirima July 2011
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Running Head: The Capital Asset Pricing Model Assignment Question 1 concerns the differences between diversifiable and undiversifiable risks associated with investment portfolios. A diversifiable risk is a risk that directly involves a single item in a portfolio. Say for instance you owned stock in KB Toy Store, Wal-Mart, and Goodyear. KB Toy Store and Goodyear are doing fine, yet Wal-Mart is losing value. Wal- Mart’s loss of value does not affect KB or Goodyear, so it does not have a particularly grim impact on your total investment. On the other hand, undiversifiable risks are risks effect the entire investment. For instance, you have stayed with the companies mentioned in the last paragraph. In this scenario, The President passes a new law which prohibits store owners from issuing store credit to customers with a salary less than $30,000 a year. This will probably have a negative effect on your entire portfolio because all three of investments are stores of some type. Scenario a, a substantial unexpected increase in inflation is an example of an undiversifiable risk. Inflation impacts the whole economy. Investopedia defines inflation as a sustained increase in the general level of prices for goods and services. Simply, it’s a period when the price of everything goes up and stays up. The key word of the definition is “general”. General is a loose term for all prices. I also believe the same for scenario b. When a country goes through a recession, businesses suffer the most. When big businesses, such as the automotive industry are slow to produce revenue, it may hazardous for investors. For example, compare a big business to a giant river. A giant river usually gets water from an even big source; a lake or the ocean, perhaps. When water comes directly
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FIN301IA3 - Running Head: The Capital Asset Pricing Model...

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