# Expected return and risk of the two assets have no

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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.

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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. 7.4 The correlation between stocks A and B is 0.50, while the correlation between stocks A and C is –0.5. You already own stock A and are thinking of buying either stock B or stock C. If you want your portfolio to have the lowest possible risk, would you buy stock B or C? Would you expect the stock you choose to affect the return that you earn on your portfolio? You would buy stock C because it would result in your portfolio having a lower beta.If you buy stock C, the required return for your portfolio would be lower than the required return would be if you bought stock B.If the expected returns on stocks C and B equal their required returns, then you would expect your portfolio to earn less with stock C. 7.5 The model where we know the return on a security for each possible outcome is overly simplistic in many ways. However, even though we cannot possibly predict all possible outcomes, this fact has little bearing on the risk-free return. Explain why.
The risk-free security delivers the same return in all states of the world. Even though we do not know all of the possible states of the world in future periods, we do know that the U.S. government will be able to repay its borrowing in every state of the world. Therefore,

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