Question

Using Securities Market Line Equation (SML, Eq. 8.7, Ch. 8) and given the information below, which of the following stock has the lowest risk? 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

Ans) Option C

To find out which stock has lowest risk we need to find out beta

Now Required rate of return = Risk free rate of return + beta(Market return - Risk free rate of return)

Option A) here required rate of return is 5%, the risk free rate is 1.5%, rate of return on market portfolio is 3%, thus

5% = 1.5% + beta(3%-1.5%)

=5% = 1.5% + beta(1.5%)

=3.5% = beta(1.5%)

= beta = 2.33

Option B) here required rate of return is 6%, the risk free rate is 1.5%, rate of return on market portfolio is 3%, thus

6% = 1.5% + beta(3%-1.5%)

=6% = 1.5% + beta(1.5%)

=4.5% = beta(1.5%)

= beta = 3

Option C) here required rate of return is 4%, the risk free rate is 1.5%, rate of return on market portfolio is 7%, thus

4% = 1.5% + beta(7%-1.5%)

=4% = 1.5% + beta(5.5%)

=2.5% = beta(5.5%)

= beta = 0.45

Option D) here required rate of return is 7%, the risk free rate is 1.5%, rate of return on market portfolio is 5%, thus

7% = 1.5% + beta(5%-1.5%)

=7% = 1.5% + beta(3.5%)

=5.5% = beta(3.5%)

= beta = 1.57

Beta is measure the risk lower the beta lesser is the risk. Thus option C has lowest beta and hence it has lowest risk