Consider the following two stocks, A and B. Stock A has an expected return of 10
ID: 2735014 • Letter: C
Question
Consider the following two stocks, A and B. Stock A has an expected return of 10%, 10% standard deviation, and a beta of 1.20. Stock B has an expected return of 14%, 25% standard deviation, and a beta of 1.80. The expected market rate of return is 9% and the risk-free rate is 5%. Security __________ would be considered a good buy if we include the stock in a well diversified a portfolio because _________.
A. B, it offers better Sharpe ratio
B. A, it offers better alpha
C. A, it offers better Sharpe ratio
D. B, it offers better alpha
Explanation / Answer
Answer : C. A, it offers better Sharpe ratio
Security A would be considered a good buy if we include the stock in a well diversified a portfolio because it offers better Sharpe ratio.
The higher the sharp ratio the higher the return the investor is getting per unit of risk.
Return according to CAPM = Rf - beta * (Rm-Rf)
Stock A =5% -1.2(9%-5%) = 9.8%
Apha stock A = 10% -9.8% = 0.2%
Stock B =5% -1.8(9%-5%) = 12.2%
Apha stock B = 14% - 12.2% = 1.8%
Sharp Ratio =(Rp-Rf) / Standard Deviation Stock A Sharp Ratio = (10%-5%)/10% = 0.5 Stock B Sharp Ratio = (14%-5%)/25% = 0.36