Two stocks, A and B, possess the following characteristics. stock A Beta: 1.08 S
ID: 2742852 • Letter: T
Question
Two stocks, A and B, possess the following characteristics.
stock A
Beta: 1.08
Standard Deviation: 0.12
stock B
Beta: 1.00
Standard Deviation: 0.18
When unsystematic risk is perfectly diversifiable then which statement about the security risk premium is most accurate?
a. stock B has the highest required risk premium because its standard deviation is largest
b. stock B has the highest required risk premium because it has the least unsystematic risk
c. stock B has the highest required risk premium because its total risk is largest
d. stock A has the highest required risk premium because its beta is largest
e. stock A has the highest required risk premium because it has the most unsystematic risk
Explanation / Answer
Stock A has highest beta ,hence it will have maximum risk premium.
Required rate of return on a stock=Risk free rate + Beta (Market return –Risk free rate)
Required rate=Risk free rate+ Beta * Risk premium
Beta is a measure of volatility .The greater the volatility of returns ,the higher the risk the security is bearing and hence it will require a higher margin of return which is excess of returns which can be earned from a risk free security.
Risk premium is the excess return that a security is expected to earn over the risk free return.
Hence ,if beta is high,the higher will be the market risk premium.
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