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#5: Consider the following information about Stock I and II:The market risk premium is 8 percent, and the risk-free rate is 4 percent. Which stock has the most systematic risk? Which one has the most unsystematic risk? Which stock is “riskier”? Explain.State of EconomyProbability of State of EconomyRate of Return if State OccursStock IStock IIRecession0.250.11-0.40Normal0.500.290.10Irrational exuberance0.250.130.568
Although Stock II has more total risk than I, it has much lesssystematic risk, since its beta is much smaller than I’s. Thus, I hasmore systematic risk, and II has more unsystematic and more totalrisk. Since unsystematic risk can be diversified away, I is actually the“riskier” stock despite the lack of volatility in its returns. Stock I willhave a higher risk premium and a greater expected return.10Stock IStock IISystematic Risk2.060.625Total Risk?0.08530.340Total RiskLowerHigherSystematic RiskMoreLessUnsystematic RiskLessMore