Question

QUESTION 16

1. If an investor buys at least 50 stocks from different industries, he or she can, through diversification, eliminate all of the company-specific risk inherent in owning stocks, but as a general rule it will not be possible to eliminate all market (systematic) risk.

   True

   False

3.5 points   

QUESTION 17

1. Stock A's beta is 0.5 and Stock B's beta is 1.5. Which of the following statements must be true about these securities? (Assume market equilibrium.)

   		When held in isolation, Stock A has greater risk than Stock B.
   		Stock B must be a more desirable addition to a portfolio than Stock A.
   		Stock A must be a more desirable addition to a portfolio than Stock B.
   		The expected return on Stock A should be greater than that on Stock B.
   		The expected return on Stock B should be greater than that on Stock A.

Answer 1

16) Systematic risk is the risk which is industry wide and can't be diversified while company specific risk also known as the idiosyncratic risk can be diversified away. Therefore the given statement is true

17) If B has greater beta, that means it has greater systematic risk than A. Due to higher risk it maybe less desirable but we can't say for sure because it might be adding other value to the portfolio so we can't comment oh which stock is more desirable. This eliminated first 3 options.

Coming to the expected return calculation, it uses the CAPM equation:

returnerpected = return risk free + B(return market - return risk free)

So keeping all things constant, the stock with higher beta will have higher expected return and that is logical too as greater risk should have a greater return to compensate. So 4rth option is also incorrect as 5th option is correct i.e.the expected return on Stock B should be greater than that on Stock A.