Question

Question 6

A stock has its past returns graphed against market returns. The line that has the best fit for the return data has the formula y = 0.335x + 0.501. What information can we derive from this?

		The systematic risk of this stock is greater than that of the average stock.
		The stock must have earned lower returns than the market during that period.
		The beta of the stock is 0.501.
		The beta of the stock is 0.335.
		The alpha of this stock is 0.335.

Answer 1

When the past returns of the stock is plotted against the market returns, we get the Security Market Line (SML)

The formula for SML is:

Comparing the above equation with y = 0.335x + 0.501,

where,

• y = ER (expected return of the stock)
• 0.501 is the risk free rate
• x = the market risk premium
• 0.335 is the beta

we can easily conclude that:

The beta of the stock is 0.335.

Hence, the correct option is Option 4 (The beta of the stock is 0.335).