Question

Assume a fictitious world where there are four stocks:

General Electric (GE)

CitiGroup (C)

British Petroleum (BP)

FaceBook (FB).

The market is in equilibrium where CAPM assumptions hold (e.g. homogeneous expectations, efficient markets, zero transaction costs, etc.)

What would be the market’s response if the ratio of the contribution to the market’s risk premium divided by the contribution to the market’s variance is higher for BP and lower for FB vs. the other two stocks?

Answer 1

When the the ratio of contribution to the market risk premium divided by the contribution to the market variance is higher for British petroleum, it will mean that British petroleum is highly exposed to the systematic risk and it is having a very low beta so it will be exposed to high systematic risk whereas if if the outcome is negative for the Facebook, then it will mean that the Facebook stock will be having a relatively lower beta and it will also mean that there is a low level of uncertainty in the investment related to portfolio of Facebook so there is always a lot of standard deviation as well because the overall risk related to investment in the Facebook is lower and it will also mean that the correlation between Facebook and the overall market rate of return is lower.

All the other stocks like citigroup and General electric will be having a mediocre beta and mediocre correlation in a respect to the overall market and their return will not be as volatile as British petroleum but they returns will be more volatile than Facebook.