Question

Your firm's research department has just informed you that over the next month they expect stock A to have a return of 2.9% and stock B to have a return of 2.5%. Market return over the same time period is expected to be 3%. If the risk-free rate is 0.25%, which, if any, of the two stocks should you buy? A) Stock A B) Stock B C) Both D) neither

Answer 1

Answer :-

Stock A :-

Expected return = Rf + Beta (Rm - Rf)

2.9% = 0.25% + Beta(3% - 0.25%)

2.65% = Beta * (2.75%)

Beta = 0.964

Stock B :-

Expected Return = Rf + Beta(Rm - Rf)

2.5% = 0.25% + Beta(3% - 0.25%) = 0.818 times

Beta = 2.25% / 2.75% = 0.818 times

As we see beta of stock B is less than Stock A so we need to invest in Stock B as it has lower risk