Which of the following statements is most correct? Expain. •Normally, the Securi

Question

Which of the following statements is most correct? Expain.

•Normally, the Security Market Line has an upward slope. However, at one of those unusual times when the yield curve on bonds is downward sloping, the SML will also have a downward slope.

•The market risk premium, as it is used in the CAPM theory, is equal to the return on an average stock minus the required rate of return on an average company’s bonds.

•If the marginal investor’s aversion to risk decreases, then the slope of the yield curve would, other things held constant, tend to increase. If expectations for inflation also increased at the same time risk aversion was decreasing – say the expected inflation rate rose from 5% to 8% - the net effect could possibly result in a parallel upward shift in the SML.

•According to the text, it is theoretically possible to combine two stocks, each of which would be quite risky if held as your only asset, and to form a 2 stock portfolio that is riskless. However, the stocks would have to have a correlation coefficient of expected future returns of –1.0, and it is hard to find such stocks in the real world.

•Each of the above statements is false.

Explanation / Answer

•According to the text, it is theoretically possible to combine two stocks, each of which would be quite risky if held as your only asset, and to form a 2 stock portfolio that is riskless. However, the stocks would have to have a correlation coefficient of expected future returns of –1.0, and it is hard to find such stocks in the real world.

Explanation: The standard deviaiton of the portfolio is sqrt(Wa^2*SDa^2+Wb^2*SDb^2+2*Wa*Wb*correl(a,b)*SDa*SDb)

SO if correl becomes -1, standard deviation becomes WaSDa-WbSDb or WaSDa-(1-Wa)SDb. This would equal zero when, Wa/(1-Wa)=SDb/SDa..Once standard debvaiiton is known, we can make the weight of each stock in the portfolio as found above and make the portfolio riskless. But is very hard to find such stocks in the real world

Why other statements are incorrect:

•Normally, the Security Market Line has an upward slope. However, at one of those unusual times when the yield curve on bonds is downward sloping, the SML will also have a downward slope. This is incorrect because even if the yield curve is downward sloping or the risk free rate is decreasing, market return will always be greater than the risk free rate and standard devaiitjon will always be positive, and hence, the slope will always be posiitve that is upward and not downward

•The market risk premium, as it is used in the CAPM theory, is equal to the return on an average stock minus the required rate of return on an average company’s bonds. This is incorrect because market risk premium is not the return on an avergae stock minus the required return on company's bonds rather it is the market return minus risk free rate

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