Question

7. There are few, if any real companies with negative betas. But suppose you found one with beta = -25. a) How would you expect this stock's rate of return to change if the overall market rose extra 5%? What if the market fell extra 5%? b) You have 1 million invested in well-diversified portfolio of stocks. Now you receive an additional $20,000 bequest. Which of the following will yield the safest overall portfolio return? i. Invest $20,000 in Treasury bills (with beta-0) ii. Invest $20,000 in stocks with beta=1 Invest $20,000 in stocks with beta=-0.25 Explain your answer.

Answer 1

7a: If the market rose by 5% then the stock will change by = -5%*(0.25) = -1.25%. Hence the stock will fall by 1.25% if market rose by 5%.

If the market fell by 5% then the stock will change by = 5%*0.25 = 1.25%. Hence the stock will rise by 1.25% if market rose by 5%.

b: The answer will be option ii – i.e. invest $20,000 in stocks with beta = 1.

This is because a well-diversified portfolio has almost negligible volatility and hence its beta tends to be near to 1. It will not be prudent to invest in T-bills as its beta is 0 and hence the additional investment will underperform the market and the diversified portfolio. A negative beta investment will not be preferred as it will negate any increase in market returns.