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

Security Market line shows relation between expected return of a security and is risk measured by its beta coefficient. SML line displays expected return for given beta or reflects risk associated with any given expected return .

Beta is an index of systematic risk. The higher beta is for any security , the higher must be expected return. Lower the Beta lower the risk.

So calculating by SML equation risk is calculated as under:

Solution: (a) re= rf+B(rm-rf) (formula)

re= Expected Return on Security

rf= Risk free rate

B= Beta

rm= Market rate of return

B= re-rf/rm-rf

re=5%

rf=1.5%

rm=3%

B= 5%-1.5%/ 3%-1.5%=3.5/1.5=2.33

B=2.33

(B) Solution

Formula for calculating Risk -   re= rf+B(rm-rf)

re= Expected Return on Security

rf= Risk free rate

B= Beta

rm= Market rate of return

B= re-rf/rm-rf

re= 6%

rf= 1.5%

rm= 3%

B= re-rf/rm-rf

6%-1.5% /3%-1.5%=4.5/1.5=3%

C) Solution

Formula for calculating Risk -   re= rf+B(rm-rf)

re= Expected Return on Security

rf= Risk free rate

B= Beta

rm= Market rate of return

B= re-rf/rm-rf

re=4%

rf= 1.5%

rm=7%

B= 4%-1.5% / 7%-1.5%= 0.45

B=0.45

D)

Formula for calculating Risk -   re= rf+B(rm-rf)

re= Expected Return on Security

rf= Risk free rate

B= Beta

rm= Market rate of return

B= re-rf/rm-rf

re= 7%

rf=1.5%

rm= 5%

7%-1.5% / 5%-1.5%=1.57

B= 1.57

So, in above a, b, c, d lower beta is 0.45 therefore, stock c has lowest risk according to security market line

ANS is C Stock