This presentation has two parts. The first part identifies verifiable and unverifiable risks in certain given scenarios. The second part of this paper deals with CAPM calculation with the given figures and the last part explains the drawbacks and advantages of using the CAPM.

Analysis
Each of the four different situations and scenarios will be analyzed as to the diversification or otherwise of the risk inherent to the scenario.
1.0 Fraudulent accounting practices

Fraudulent accounting practices would entail a very bad and hostile media. This is specially so after the scams involving WorldCom, Enron and Xerox Corporation. Investigative journalists (including those in The New York Times) have even discovered such corporate wrongdoings in businesses that are linked to President Bush and Vice-President Dick Cheney. Therefore the issue has been brought into sharp focus and a business indulging in such a practice is sure to be censured by the public, media and also grilled by the official agencies. Insider trading, capitalizing operating expenditure, book fictitious (unaccrued) revenue, to jack up stock prices and unload personal holdings before the discovery are now well known tricks. And what of the risk diversification? To be sure once the erring business is under the official microscopic examination the escape route is almost cut off. It has to bear the consequences in the manner prescribed by the law. Of course a team of highly paid high-profile lawyers can go a long way in diverting the focus and doing a fine damage control job. But accounting manipulations leave a trail and can be uncovered even when camouflaged. It would appear that under this given situation the degree of risk diversification is limited.

The above applies to the business corporation itself. The official would at worse resign and be given another assignment elsewhere by the vested interests.
(The Hindu Business Line : Corporate scams in US: Roots 2004)
2.0 A major terrorist attack occurs in the U.S. again.
The September 11 attacks were sudden and unprecedented. If American is to face another such eventuality it is better prepared today. Besides the degree of preparedness the rescue and relief operations would have gained similar improvements.

It is entirely possible to plan new growth in widely separate geographical areas so as to diversify the risk. This is possible even in case of most of the existing business though relocation may add costs dimension at least in the short run. If enough business undertake relocations then the chances for the businesses to find convenient locations with suitable facilities would become easier.
3.0 A large increase in the price of oil

Rise in the price of oil sends shudders down the spine of business managers. The alternative fuels like the renewable ethanol; hydrogen or cold fusion are still in the laboratories and quite some time away from being brought into commercial use. The risk cannot be diversified in the choice of fuel. Contracts in the futures market for oil presents one such cushion against sudden and very high hikes in the price of oil. In this case however the risk is extra cost in case there is no major price increase. It is not possible to synchronize production schedules in line with periods when oil is cheap and plentiful. The disruptions in production planning and scheduling and inventory management would present insurmountable problems.
4.0 The CEO of a major corporation is involved in a sex scandal
This is the easiest situation to get out of and diversify the risk. A well choreographed spin-doctoring campaign and right media contacts will confuse the issue and there is a chance of the damage control exercises to finish off the job. The CEO can be sent on a furlough ad told to lie low till the storm is blown off. Or if the board is sincere then the CEO can be sent packing and a person of better repute brought in.

a. Find the Expected Return on the Market Portfolio given that the Expected Return on Asset I is 7%, the Risk-Free Rate is 2.5%, and the Beta for Asset I is 1.5.

The formula to be applied is as follows:

Ks = Krf + B (Km – Krf)
• Ks = The Required Rate of Return, (or just the rate of return).
• Krf = The Risk Free Rate (the rate of return on a "risk free investment", like U.S. Government Treasury Bonds
• B = Beta
• Km = The expected return on the overall stock market. (You have to guess what rate of return you think the overall stock market will produce.)
(CAPM 2004)
KS = 2.5+1.5(7%-2.5)
= 2.5+1.5(4.5)
= 2.5+ 6.75
= 9.25

b. Find the Risk-Free Rate given that the Expected Return on Asset i is 10%, the Expected Return on the Market Portfolio is 5%, and the Beta for Asset i is 1.5.
KS = 1.5(5)
= 7.5

c. What will happen to the Beta of a diversified stock portfolio as more stocks are added to it?
There is an inverse relationship between diversification of the portfolio and the element of risk. Therefore if more stocks are added to the portfolio it is more likely for the element of risk to go down. The beta’s risk compared to the overall market’s risk is likely to go down.

CAPM: Advantages and drawbacks
Advantage is that CAPM links the required return directly to risk. It is of particular use when a business is looking to add to its activities and the new activity has a different risk than the business’ existing activities. The risk of the firm will thus change and therefore equity cost of capital will be different in future from what it is at present.

The major drawback is that the beta is based on past performance and the future may not be like the past. Another problem is finding a quoted firm that has single activity. Another drawback is the gearing differences.