Question

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Which of the following assets has the highest beta?

• A. Shares in a mutual fund that tracks the S&P500 index.
• B. A portfolio of shares of utilities companies operating across the USA.
• C. A portfolio of US Treasury bills.
• D. Shares in a construction company.
• E. Shares on General Mills (manufacturers of basic packaged foods).

Since the beginning of the month the S&P500 index has fallen by 16%. All of the following statements might explain this change EXCEPT:

• A. The market believes that firm's free cash flows have become significantly more risky.
• B. The market risk premium has increased.
• C. Stock prices have fallen because investors require lower returns to invest in risky assets.
• D. The market expects firms' future free cash flows to be significantly lower than previously forecast.
• E. Investors have become more risk averse.

Answer 1

1]

Beta is a measure of the systematic risk. It measures the sensitivity of the asset's returns to the returns of the overall market.

The answer is D. The business of construction companies has a high sensitivity to the business cycle. Thus, in a booming economy when the overall market is doing well, the returns of shares of construction companies tend to exceed the returns of the overall market. The opposite is true during a recession. The returns of shares of construction companies during a recession tend to be lower than the returns of the overall market.

A is incorrect. The beta of the overall market is 1.

B is incorrect. Utility companies tend to have a beta lower than 1 as their business is relatively stable during upswings as well as downswings.

C is incorrect. Treasury bills have a beta of zero

E is incorrect. Packaged food companies tend to have a beta lower than 1 as their business is relatively stable during upswings as well as downswings.

2]

C is the correct option. Investors require higher returns to invest in risky assets.

The fall in S&P 500 can be explained by :

• The cash flows of companies are perceived to be more risky
• An increase in the market risk premium, i.e. an increase in the premium required to invest in risky assets
• Expected lower future cash flows
• Risk aversion in investors