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Chapter 17: Q7. (page 368)

If we compare the betas of various investment opportunities, why do the assets that have higher betas also have higher average expected rates of return?

Short Answer

Expert verified

The beta value is higher for assets with a higher risk and a higher average expected return, and hence higher betas mean higher returns.

Step by step solution

01

Step 1. Explanation

The assets having a higher beta indicate a higher level of non-diversifiable risk than the other market portfolio. The average expected rate of return is the probability-weighted average of the investment’s possible future rates of return. When beta is higher, the probability of earning a high return is very high. The higher weightage of higher returns increases the average expected rates of returns.

Note: more-risky investments end up with lower prices and, consequently, higher rates of return.

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Most popular questions from this chapter

Suppose that an SML indicates that assets with a beta = 1.15 should have an average expected rate of return of 12 percent per year. If a particular stock with a beta = 1.15 currently has an average expected rate of return of 15 percent, what should we expect to happen to its price?

  1. Rise.

  2. Fall.

  3. Stay the same.

Suppose that the equation for the SLM is Y = 0.05 + 0.04X, where Y is the average expected rate of return, 0.05 is the vertical intercept, 0.04 is the slope, and X is the risk level as measured by beta. What is the risk-free interest rate for this SML? What is the average expected rate of return at a beta of 1.5? What is the value of beta at an average expected rate of return is 7 percent?

Suppose initially that two assets, A and B, will each make a single guaranteed payment of \(100 in 1 year. But asset A has a current price of \)80 while asset B has a current price of $90.

  1. What are the rates of return of assets A and B at their current prices? Given these rates of return, which asset should investors buy and which asset should they sell?

  2. Assume that arbitrage continues until A and B have the same expected rate of return. When arbitrage ends, will A and B have the same price?

Tammy can buy an asset this year for \(1,000. She is expecting to sell it next year for \)1,050. What is the asset’s anticipated percentage rate of return?

  1. 0 percent

  2. 5 percent

  3. 10 percent

  4. 15 percent

It is a fact that (1 + 0.12)3 = 1.40. Knowing that to be true, what is the present value of \(140 received in three years if the annual interest rate is 12 percent?

  1. \)1.40

  2. \(12

  3. \)100

  4. $112
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