Question

Everyone agrees stock A is riskier than stock B, but they have the same expected return.

(a) Which would you prefer to buy? Why?

(i) Stock A.

(ii) Stock B.

(b) In order for someone to want to hold the stock, you don't like, what would have to happen to the price of that stock, assuming the other stock remains unchanged? Why?

(i) Price goes up.

(ii) Price goes down.

(c) If the price changes as described in (b), what happens to expected returns? Why?

(i) Expected returns go up.

(ii) Expected return go down.

Answer 1

(a) Which would you prefer to buy? Why?

A stock is said to dominate the other, if it has;

1. High expected return but same risk or
2. Low risk but have same expected return.

So in this case stock B is preferable, it has low risk but have same expected return.

(b) In order for someone to want to hold the stock, you don't like, what would have to happen to the price of that stock, assuming the other stock remains unchanged? Why?

Buy and hold is a passive strategy where the investor buys a stock and hold it for a long period of time irrespective of market fluctuations. In such cases, investor intends to buy at lower price and sell at higher price. Hence the price would have to goes up.

(i) Price goes up.

(c) If the price changes as described in (b), what happens to expected returns? Why?

Stock price and expected return have inverse relationship. That is when the stock price increases,expected return decreases and vice-versa

(ii) Expected return go down.