Question

Assume the CAPM is correct and also that markets are efficient. You are looking at two different stocks. IBX has a beta of 1.25 and Microsquish has a beta of 1.95. Which statement is true about these investments?

A) IBX is always a better addition to your portfolio.

B) Microsquish is always a better addition to your portfolio.

C) The expected return on IBX will be the higher of the two.

D) You cannot tell which of the two will have the higher expected return without further information.

E) The IBX stock has the same Security Market Line (SML) slope as does the Microsquish stock.

Answer 1

A. Is wrong because the investor may want to take exposure in risky stocks. IBX has low beta but the goals of the investors portfolio is important before saying anything. A low risk offers lower potential returns.

B. Is wrong again for above reasons. Investor may not want to take high risk. The beta indicates Microsquish has higher systematic risk.

C. Wrong as it has smaller beta of the two. According to CAPM, the return will be lower.

Re= Rf+Beta*(Rm-Rf) as beta is less returns would be lower.

D. According to CAPM, the above equation holds and the only variable above is beta. We have that information hence , we can be sure that Microsquish will have higher expected return as it has higher beta. Hence, this option is wrong.

E. Correct. The slope of the Security market line is market risk premium (Rm-Rf), which is same for both stocks