Question

Parts a, b, and c of this question are independent of one another.

a) Please fill in the blank in the question below: The risk premium of a security is determined by __. (Answer in terms of systematic risk versus diversifiable risk – choose one of these two options.)

b) Please fill in the blank in the question below: In equilibrium, the risk premium for bearing diversifiable risk equals ____.

c) Identify each of the following risks as most likely to be systematic risk or diversifiable risk:

i. The risk that the economy slows, decreasing your sales. 

ii. The risk that the most productive employees leave your company.

Answer 1

a. The risk premium of a security depends on its systematic risk or undiversifiable risk. Diversifiable or unsystematic risk can be diversified or eliminated by using diversification. As this risk can be diversified or eliminated investors do not need to be compensated for it. As investors cannot diversify systematic risk, they should be compensated for it.

b. As investors are not compensated for bearing diversifiable risk the risk premium is zero. In equilibrium, the risk premium for bearing diversifiable risk equals zero.

c. i. This statement indicates a systematic risk or market wide risk as all firms will be affected if economy slows down. This is not a firm specific risk.

ii. This statement indicates an unsystematic risk/diversifiable risk or firm specific risk. This risk affects the particular firm only.