Stock X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the following statements is CORRECTσ
A) stock y must have a higher expected return and a higher standard deviation than stock x.
B) if expected inflation increases but the market risk premium is unchanged, then the required return on both stocks will fall by the same amount.
C) if the market risk premium declines but expected inflation is unchanged, the required return on both stocks will decrease, but the decrease will be greater for stock y.
D) if expected inflation declines but the market risk premium is unchanged, then the required return on both stocks will decrease but the decrease will be greater for stock y.
E) a portfolio consisting of $50,000 invested in stock x and $50,000 invested in stock y will have a required return that exceeds that of the overall market.

Question

Quizplus · Accepted Answer

The required return on both stocks is determined by the risk-free rate, the market risk premium, and the stock's beta. However, the beta of stock Y is higher than that of stock X, which means stock Y is riskier than stock X. Therefore, according to the CAPM model, stock Y should have a higher required return than stock X.

Option A is incorrect because the expected return and standard deviation are not solely determined by beta but also by other factors such as the risk-free rate and the market risk premium.

Option B is incorrect because an increase in expected inflation will increase the required return on both stocks as investors demand higher returns to compensate for the higher inflation risk.

Option D is incorrect because a decrease in expected inflation will lower the required return on both stocks as investors demand less compensation for the lower inflation risk.

Option E is irrelevant as it does not relate to the statement about beta and required return.

Stock X Has a Beta of 0