Which of the following statements concerning market (or firm-specific) risk are true?
I. The reward for holding a firm’s stock would increase as its firm-specific risk increases.
II. Market risk can be avoided as long as you hold a market portfolio.
III. The expected return of a firm’s stock is higher when its beta is higher.
Answer - Option III
Market compensates the investor only for bearing systematic or market risk. This is because the market expects firm-specific risk or undiversifiable risks to be eliminated via diversification. Hence, Option one is false.
Also, market risk cannot be eliminated. It would be there in a well-diversified market portfolio as well. Hence Option two is false as well.
Based on CAPM, higher the beta, higher is the systematic risk and hence, higher would be the expected return. Since, based on financial principle, higher the risk, higher the return.
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