Question

Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements...

Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true, assuming the CAPM is correct.

a. Stock A would be a more desirable addition to a portfolio then Stock B.
b. Stock B would be a more desirable addition to a portfolio than A.
c. When held in isolation, Stock A has more risk than Stock B.
d. In equilibrium, the expected return on Stock B will be greater than that on Stock A.
e. In equilibrium, the expected return on Stock A will be greater than that on B.

Homework Answers

Answer #1

Answer: Option e is correct.

According to the equation of capital asset pricing model (CAPM):
Expected return=Risk free rate +Beta*(Market risk premium)
So, from the equation we can see that the stock with higher value of beta will have higher expected return.
The beta of stock A is higher than the beta of stock B.
Hence, in equilibrium, the expected return on stock A will be greater than that on stock B.

Option a and b are not correct because there are many factors that govern the addition of a stock to a portfolio, only higher or lower beta values does not make a stock desirable or undesirable.
Option c is not correct because beta is measured with respect to market. When held in isolation, we cannot say that Stock A has more risk than Stock B.  
Option d is not correct because as the beta value is more for stock A, its expected return will be more that stock B.

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