Question

Returns on technology stocks tend to be greater than the market average while the opposite is true for utility stocks. Do you expect a tech stock’s beta to be greater than, about the same or less than the market beta? Same question for the utility stock.

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If the Security Market Line becomes steeper, how does that impact the required return for a stock and what is the impact to the stock’s beta? (This is a two-part question.)

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How does changing the inflation expectation affect the beta of the stock?

Answer 1

Returns on technology stocks tend to be greater than the market average while the opposite is true for utility stocks. Do you expect a tech stock’s beta to be greater than, about the same or less than the market beta? Same question for the utility stock.

Risk return profile of a security go hand in hand. Technically, in order to avoid arbitrage, a stock with higher return should also have higher risk associated with it. Hence it should have higher beta as beta is an indicator of the risk profile of the stock.

As the returns on technology stocks > market average

Hence, the risk associated with technology stocks > riskiness of the market portfolio

Hence, beta of technology stock > Market beta.

As the returns on utility stocks < market average

Hence, the risk associated with utility stocks < riskiness of the market portfolio

Hence, beta of the utility stock < Market beta.

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If the Security Market Line becomes steeper, how does that impact the required return for a stock and what is the impact to the stock’s beta? (This is a two-part question.)

The slope of the Security Market Line is the market risk premium = R_M - R_F where R_M = Expected return from market and R_F is the risk free rate. Thus, the steeper the slope of the security market line, the higher will be the risk premium for all stocks, and hence the higher will be the required return. Thus, if the Security Market Line becomes steeper, the required return of a stock will increase.

In the SML equation, expected return is a dependent variable (y-axis) and Beta is the independent variab (x-asis). Hence, steepness or flatness of the Security Market Line will not have any impact on the stock's beta.

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How does changing the inflation expectation affect the beta of the stock

There is no direct response to this question. Changing the inflation expectation can change the expected return on the stock and this may change the SML also. But this should not change the beta of the stock. Empirical studies have shown beta's neutrality to inflation expectation. Hence, changing the inflation expectation should not affect the beta of the stock.