Question

Suppose that there are two stocks which have the following information:

E(R₁) = 10%, E(R₂) = 11%, Beta₁ = 1.4, Beta₂ = 1.8, R_f = 5%

Which stock do you want to choose and why?

1) Stock 1 because its risk premium is high.

2) Stock 1 because its reward-to-risk ratio is high.

3) Stock 2 because its reward-to-risk ratio is high.

4) Stock 2 because its risk premium is high.

Answer 1

E(R1) = 10%

E(R2) = 11%

Beta1 = 1.4

Beta2 = 1.8

Rf = 5%

Since Beta and Risk-Free Rate is given, let's calculate the reward to risk ratio for both of the stocks:

(Return of Stock - Risk-Free Rate) / Beta

For Stock 1, it is (10% - 5%)/1.4 = 3.571

For Stock 2, it is (11% - 5%) / 1.8 = 3.333

For Stock 1, The reward to risk ratio is high.

The correct answer is Option 2(Stock 1 because its reward to risk ratio is high).