Based on the security market line, Company C-A stock has a required return of 7%

Question

Based on the security market line, Company C-A stock has a required return of 7% and company C-B has a required return of 5%. C-A has a standard deviation of returns of 9%. Therefore

A) C-B must have a standard deviation of returns of less thn 9% because C-B is less risky than C-A.

B) The beta for C-B must be greater than the beta for C-A because C-B is the better buy for a risk-averse investor.

C) All rational investors will prefer C-B over C-A

D) For a well diversified investor, C-B is less risky than C-A.

Explanation / Answer

The SML tells that individuals stock return is equal to risk-free rate plus a premium for bearing risk. The premium for risk is the premium for market (Rm) multiplied by the risk of the individual stock, as measured by its beta coefficient. The SML tells us that the standard deviation should not be used to measure the risk of a stock, becasue some of the risk as reflected by standard deviation can be eliminated by diversification. Beta reflects risk after taking diversification benefits into account. So, beta rather than standard deviation is used to measure individual stocks risks to investors. Therefore, the correct option is D) For a well diversed investor, C-B is less risky than C-A.

Related Questions

Navigate

• Browse (All)
• Browse B
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.