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Stock - Risk and Return

A. Common stock A has an expected return of 10%, a standard deviation of future returns of 25%, and a beta of 1.25. Common stock B has an expected return of 12%, a standard deviation of future returns of 15%, and a beta of 1.50. Which stock is riskier? Explain.

b. Suppose rf is 5% and rM is 10%. According to the SML and the CAPM, an asset with a beta of -2.0 has a required return of negative 5% [= 5 - -2(10 - 5)]. Can this be possible? Does this mean that the asset has negative risk? Why would anyone ever invest in an asset that has an expected and required return that is negative? Explain.

Solution Preview

a. The riskiness of the stock depends on whether it is taken on a standalone basis or a part of a portfolio. On a standalone basis we look only at that stock and so the risk is measured by the standard deviation of the returns. If we look at the stock from a portfolio perspective, then we look at the impact of the stock on the riskiness of the portfolio and this ...

Solution Summary

The solution explains how to determine which stock is riskier and why invest when return is expected to be negative.