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Chapter 7
Risk and Return
Critical Thinking Questions
7.1
Given that you know the risk as well as the expected return for two stocks, discuss what
process you might utilize to determine which of the two stocks is a better buy. You may
assume that the two stocks will be the only assets held in your portfolio.
You should be looking to maximize your expected return on an investment given the
level of risk that such an investment requires the investor to bear. Therefore, you should
compare the expected return and risk associated with each of the two stocks. If the stocks
have the same expected return, then choose the stock with the lower risk. If the stocks
have the same risk, then choose the stock with the greatest expected return. If the
expected return and risk of the two assets have no common level, perhaps you should
compare the ratio of the risk/expected return to see which stock contains the least risk per
unit of expected return.
7.2
What is the difference between the expected rate of return and the required rate of return?
What does it mean if they are different for a particular asset at a particular point in time?
The required rate of return is the rate of return that investors require to compensate them
for the risk associated with an investment. The expected return will not necessarily equal
the required rate of return. The expected return can be lower, in which case the return will
not be sufficient to compensate the investor for the risk associated with the investment if
the expected return is realized. It can also be higher, in which case the expected return
will be greater than that necessary to compensate the investor for the riskiness of the
asset.
7.3
Suppose that the standard deviation of the returns on the shares of stock at two different
companies is exactly the same. Does this mean that the required rate of return will be the
same for these two stocks? How might the required rate of return on the stock of a third
company be greater than the required rates of return on the stocks of the first two
companies even if the standard deviation of the returns of the third company’s stock is
lower?
No. Because some risk can be diversified away, it is possible that two stocks with the
same standard deviation of returns can have different required rates of return. One of these
stocks can have a higher systematic risk than the other stock and, therefore, a higher
required rate of return. The third stock can have a higher required rate of return if its
systematic risk is greater than the systematic risk of the stock in the other two companies.

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