Question

6. How does the impact of default change between first mortgage, second mortgage bonds, debentures and subordinated debentures?
7. What is the difference between systematic risk and unsystematic risk?
8. Using CAPM, what is the required rate of return on an investment in Capital Inc if it has a beta of 1.25, and the market return is expected to be 10% and the risk free rate is 6%? What is the required rate of return if the risk free rate drops to 3%?

Answer 1

Systematic Risk:

1. That point of total risk that cannot be eliminated by Diversification.

2. Arises due to general factors. Ex: Interest Rate, Inflation Rate, Government Policies etc

3. it is also known as Un- Avoidable risk or Non- Diversifiable Risk or Market Risk.

UnSystematic Risk:

1. That part of total risk which can be eliminated by Diversification.

2. Arises due to specific factors like changes in market demand, Competitive Environment etc

3. Also known as Diversifiable risk or Avoidable risk

8. Required Return =Risk free return + Beta (Return in market - Risk free return)

RR = 6+1.25(10-6)

RR= 11%

If Risk Free Rate is 3%

RR= 3+1.25(10-3)=11.75%