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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?
The beta value is higher for assets with a higher risk and a higher average expected return, and hence higher betas mean higher returns.
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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?
Rise.
Fall.
Stay the same.
Next, consider another pair of assets, C and D. Asset C will make a single payment of \(150 in one year while D will make a single payment of \)200 in one year. Assume that the current price of C is \(120 and that the current price of D is \)180.
c. What are the rates of return of assets C and D at their current prices? Given these rates of return, which asset should investors buy and which asset should they sell?
d. Assume that arbitrage continues until C and D have the same expected rate of return. When arbitrage ends, will C and D have the same price?
Compare your answers to questions a through d before answering question e.
e. We know that arbitrage will equalize rates of return. Does it also guarantee to equalize prices? In what situations will it equalize prices?
Suppose that the Federal Reserve thinks that a stock market bubble is occurring and wants to reduce stock prices. What should it do to interest rates?
How do stocks and bonds differ in terms of the future payments that they are expected to make? Which type of investment (stocks or bonds) is considered to be more risky? Given what you know, which investment (stocks or bonds) do you think commonly goes by the nickname 鈥渇ixed income鈥�?
Consider another situation involving the SML. Suppose that the risk-free interest rate stays the same, but that investors鈥� dislike of risk grows more intense. Given this change, will average expected rates of return rise or fall? Next, compare what will happen to the rates of return on low-risk and high-risk investments. Which will have a larger increase in average expected rates of return, investments with high betas or investments with low betas? And will high-beta or low-beta investments show larger percentage changes in their prices?
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