One of the most important features of portfolios is to reduce risk. Your fellow students are asking you to explain some key terms ,applied to some real-world examples.

a) How does diversification reduce risk? Say you currently hold stocks of Qantas and you are planning to add stocks on one additional company to your portfolio: Delta Air or Apple. Which would be more suitable for diversification? Why do you think so? 

b) Explain how CAPM works, i.e. how does it determine the required rate of return of a stock. Does it include systematic risk, firm-specific risk or both? 

c) Your friend does not understand the idea of the Sharpe ratio. Explain in simple language. How is it used in portfolio optimisation to find the optimal portfolio? Explain. 

Answer rating: 100% (QA)

a Diversification reduces risk by spreading your investments across different assets and asset classes This helps to minimize the impact of any single ... View the full answer