Investment in portfolio A has a standard deviation of 9%, while investment in po
ID: 2757643 • Letter: I
Question
Investment in portfolio A has a standard deviation of 9%, while investment in portfolio B has a standard deviation of 14%. In order to tolerate the increased risk, what would you as an investor expect?
a. A higher expected return for portfolio A.
b. A higher expected return for portfolio B.
c. An equal return for either portfolio A or portfolio B.
d. Avoidance of portfolio B.
The required rate of return for an investment can be calculated from the capital asset pricing model as follows:
Use only the return on 3-month Treasury bills to determine the required return.
Use the beta of the investment to determine the required return.
Use the risk-free rate, plus the investment’s beta times a premium for systematic risk.
Use the risk-free rate, plus the investment’s beta times a premium for diversifiable risk.
a.Use only the return on 3-month Treasury bills to determine the required return.
b.Use the beta of the investment to determine the required return.
c.Use the risk-free rate, plus the investment’s beta times a premium for systematic risk.
d.Use the risk-free rate, plus the investment’s beta times a premium for diversifiable risk.
Explanation / Answer
Risk and expected returns move in the same direction. If risk increases expected return will increase and vice-versa. Investors expect high return for risky stocks to compensate the risk undertaken.
Hence, correct option is b. A higher expected return for portfolio B.
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