Question

Using Securities Market Line Equation and given the information below, which of the following stock has the lowest risk? (2 pt.)

	a.	Stock with the required rate of return is 5%, the risk free rate is 1.5%, rate of return on market portfolio is 3%
	b.	Stock with the required rate of return is 6%, the risk free rate is 1.5%, rate of return on market portfolio is 3%
	c.	Stock with the required rate of return is 4%, the risk free rate is 1.5%, rate of return on market portfolio is 7%
	d.	Stock with the required rate of return is 7%, the risk free rate is 1.5%, rate of return on market portfolio is 5%

Answer 1

The Security Market Line (SML) is the graphical representation of Capital Asset Pricing Model (CAPM).It measures the relationship between expected return and risk of investing in a security.

The Securities Market Line Equation is as below :

ERa = RFR + B * (ERm - RFR)

where,
ERa = Expected Return on the security
RFR = Risk Free Rate
ERm = Expected Return on Market
B = Beta

Beta is the measure of Risk of a secuirity

Calculation of Risk using the above equation

a) Stock with the required rate of return is 5%, the risk free rate is 1.5%, rate of return on market portfolio is 3%

ERa = RFR + B * (ERm - RFR)
5% = 1.5% + B * ( 3% - 1.5%)
3.5% = B * 1.5%
B = 2.33

b) Stock with the required rate of return is 6%, the risk free rate is 1.5%, rate of return on market portfolio is 3%

ERa = RFR + B * (ERm - RFR)
6% = 1.5% + B * ( 3% - 1.5%)
4.5% = B * 1.5%
B = 3

c) Stock with the required rate of return is 4%, the risk free rate is 1.5%, rate of return on market portfolio is 7%

ERa = RFR + B * (ERm - RFR)
4% = 1.5% + B * (7% - 1.5%)
2.5% = B * 5.5%
B = 0.45

d)Stock with the required rate of return is 7%, the risk free rate is 1.5%, rate of return on market portfolio is 5%

ERa = RFR + B * (ERm - RFR)
7% = 1.5% + B * (5% - 1.5%)
5.5% = B * 3.5%
B = 1.57

Ans : Stock with the required rate of return of  4%, the risk free rate of 1.5%, rate of return on market portfolio of 7% has the lowest risk i.e. Beta of 0.45