Stocks that have more risk should have a higher expected return:Group of answer choicesbased on total riskprimarily based on unsystematic riskprimarily based on systematic risk
Question
Stocks that have more risk should have a higher expected return:Group of answer choicesbased on total riskprimarily based on unsystematic riskprimarily based on systematic risk
Solution 1
The expected return of a stock is primarily based on systematic risk.
Systematic risk, also known as market risk, is the risk that affects all companies in the market. It is unpredictable and cannot be completely eliminated through diversification. This type of risk includes changes in the economy, interest rates, or political instability.
Investors require a
Solution 2
The expected return of a stock is primarily based on systematic risk. Systematic risk, also known as market risk, is the risk that affects all companies in the market. It's the risk that cannot be eliminated through diversification.
This is based on the Capital Asset Pricing Model (CAPM), which calculates the expected return of an asset based on its systematic risk. According to CAPM, stocks with higher systematic risk should have a higher expected return to compensate investors for taking on the increased risk.
Unsystematic risk, on the other hand, is the risk that is specific to a particular company. This risk can be reduced through diversification. Therefore, it's not the primary factor in determining a stock's expected return.
Total risk includes both systematic and unsystematic risk. While it's true that stocks with higher total risk should have a higher expected return, it's the systematic risk that primarily determines this, as unsystematic risk can be mitigated.
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