Which of the following statements is CORRECT? a. If investors become more risk averse, then (1)...

Which of the following statements is CORRECT?

a. If investors become more risk averse, then (1) the slope of the SML would increase and (2) the required rate of return on low-beta stocks would increase by more than the required return on high-beta stocks.

b. A graph of the SML as applied to individual stocks would show required rates of return on the vertical axis and standard deviations of returns on the horizontal axis.

c. An increase in expected inflation, combined with a constant real risk-free rate and a constant market risk premium, would lead to identical increases in the required returns on a riskless asset and on an average stock, other things held constant.

d. The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt.

e. If two "normal" or "typical" stocks were combined to form a 2-stock portfolio, the portfolio's expected return would be a weighted average of the stocks' expected returns, but the portfolio's standard deviation would probably be greater than the average of the stocks' standard deviations.

Solutions

Expert Solution

If investors are more risk averse they shall not want to take risk and hence the market risk premium would increase leading to increase in the slope of security market line. Also for low beta stock, the required rate of return as calculated by Capital Asset pricing model shall increase by less amount than for stock with high beta. The difference shall be directly proportional to beta so statement (a) is False.

In security market line graph, beta is on horizontal axis and return is on vertical axis so, statement (b) is false.

increase in expected inflation with constant real risk free rate will increase the nominal risk free rate as well as the stocks required rate of return, hence it would result in higher required rate of return on a riskless asset and stocks so given statement (C) is TRUE.

Capital Asset pricing model is not beyond doubt so given statement (d) is Incorrect.

Standard deviation of portfolio of any two normal stock shall be less than the stocks weighted average standard deviation. It is equal only when the correlation coefficient between the two stock is +1. Hence, given statement is false.

Correct answer is option (C).

jeff jeffy answered 1 year ago

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