Question

Which one of the following is a correct statement concerning the excess return?

• The lower the average rate of return, the greater the excess return.

• The lower the volatility of returns, the greater the expected excess return.

• The excess return is not affected by the volatility of returns.

• The excess return is not correlated to the average rate of return.

• The greater the volatility of returns, the greater the expected excess return.

Answer 1

Excess return is the return an investor expects over risk-free return as an incentive to invest in riskier assets. We'll use CAPM to gauge each statement

As per CAPM

R_f  is the risk-free rate.
R_m is the average return of the market
Beta is a measure of volatility

Statement 1-
When the average rate of return (R_m) is lower, from the equation above we can see the cost of equity will be lower. Hence statement 1 is incorrect

Statement 2 -
Lower the volatility, lower will be the value of beta. Hence the cost of equity would also be lower. Hence statement 2 is incorrect

Statement 3 -
Cost of equity is affected by volatility through beta, hence statement 3 is incorrect

Statement 4 -
Excess return is related to the average rate of return as per the equation, Hence statement 4 is incorrect

Statement 5 -
Greater the volatility, greater will be the value of beta. Hence from the equation, higher will be the value of the cost of equity. Hence expected excess returns would be higher. Hence statement 5 is correct

Statement 5 is correct