Question

Assume that we are living in a perfect capital market, there are no arbitrage opportunity, transaction costs or any other frictions. You are considering investing your money in two stocks. Stock A has no ideosyncratic risk. Stock B has high idiosyncratic risk. Which of the following statement is correct?

A) Youwill require higher return on stock B, since it yields higher idosyncratic risk than stock A

B) When market is booming, stock B has better return than stock A. When market is down, stock B has worse return than Stock A.

C) Stock A and B could have the same expected return.

D) Since Stock A has no idiosyncratic risk, Stock A has less risk than stock B. You would prefer investing your money in Stock A than stock B

Answer 1

A) Yes, to compensate for the higher risk one would require higher return to invest in B.
B) No, A market boom does not guarantee that B will go up or whether B will go down. Similarly market gloom does not guarantee that B will go down more.
C) Yes, Stock A and B could have the same expected return despite having different levels of idiosyncratic risk.
D) No, A risk taking individual would prefer B and a risk averse person would prefer A for the same levels of return