Unit 3: Risk and Return

Answer: D — Investment B has a higher expected return (8%) compared to Investment A (5%), but it also comes with a higher standard deviation (10%) compared to Investment A (2%). This indicates that Investment B has a higher expected return but also a higher level of risk. Option A is incorrect because Investment A is less risky than Investment B. Option B is incorrect because while Investment B does have a higher risk premium, this is not the statement being asked about. Option C is incorrect because the two investments do not have the same risk-return tradeoff.

Answer: B — The correct answer is B because the investor is willing to take on more risk for higher returns. The stock has a higher expected return than the bond, and the excess return over the risk-free rate is greater for the stock (15% - 3% = 12%) than for the bond (5% - 3% = 2%). This indicates that the stock has a higher risk premium, which is the excess return demanded by investors for taking on more risk. The other options are incorrect because they do not accurately reflect the investor's willingness to take on more risk for higher returns or they misinterpret the relationship between risk and return.

Answer: C — Correct answer C is accurate because it acknowledges that Portfolio B has a higher expected return, but also a higher level of risk. This requires the investor to consider their risk tolerance when making a decision. Option A is incorrect because a lower standard deviation does not necessarily make a portfolio more attractive. Option B is incorrect because it ignores the higher standard deviation of Portfolio B. Option D is incorrect because the Sharpe ratio is not provided, and it is not possible to determine which portfolio has a higher Sharpe ratio based on the information given.

Answer: B — The correct answer is B because the expected return per unit of risk, also known as the Sharpe ratio, is higher for Portfolio B. To calculate the Sharpe ratio, we divide the expected return by the standard deviation. For Portfolio A, the Sharpe ratio is 8%/10% = 0.8, and for Portfolio B, the Sharpe ratio is 12%/15% = 0.8. However, since the question is about which portfolio has a higher expected return per unit of risk, we need to consider that Portfolio B has a higher expected return and a higher standard deviation, but the increase in expected return is proportionally greater than the increase in standard deviation. Options A, C, and D are incorrect because they do not accurately reflect the relationship between the expected returns and standard deviations of the two portfolios.

Answer: C — Correct answer C is true because Portfolio B has a higher expected return, but it also comes with higher risk as measured by standard deviation. This illustrates the risk-return tradeoff, where investments with higher expected returns often come with higher risk. Option A is incorrect because while Portfolio A has a lower standard deviation, its expected return is also lower. Option B is incorrect because Portfolio B actually has a higher standard deviation, not a lower one. Option D is incorrect because Portfolio A has a lower expected return, not a higher one.