Two Stocks' Risk Comparison: Rich Shaw Inc. vs. Melon Inc.

Relative Risk Analysis: Rich Shaw Inc. vs. Melon Inc.

Prev Question Next Question

Question

Two stocks, Rich Shaw Inc., and Melon Inc., have identical total risk. The Rich Shaw stock risk is comprised of 60% systematic risk and 40% unsystematic risk, while the Melon stock risk is comprised of 40% systematic risk and 60% unsystematic risk. Relative to the Melon stock, the Rich Shaw stock has:

Answers

Explanations

Click on the arrows to vote for the correct answer

A. B. C.

A

To determine the required return for the two stocks, Rich Shaw Inc. and Melon Inc., we need to understand the relationship between risk and required return. According to the Capital Asset Pricing Model (CAPM), the required return on an investment is based on two components: the risk-free rate and the risk premium.

The risk premium is calculated by multiplying the asset's beta (systematic risk) by the market risk premium. The market risk premium is the difference between the expected return on the market and the risk-free rate. The beta represents the sensitivity of the asset's returns to the overall market returns.

Given the information provided, we can compare the systematic and unsystematic risk components of the two stocks:

  • Rich Shaw Inc.: 60% systematic risk and 40% unsystematic risk.
  • Melon Inc.: 40% systematic risk and 60% unsystematic risk.

Since the total risk is identical for both stocks, it means that the sum of systematic and unsystematic risk must be the same. However, the allocation of risk between systematic and unsystematic components differs.

Now, let's consider the required return for each stock:

  1. Rich Shaw Inc.: Since Rich Shaw Inc. has a higher proportion of systematic risk (60%) compared to Melon Inc., it means that it is more influenced by overall market movements and economic factors. Higher systematic risk generally results in a higher beta, indicating higher expected returns. Therefore, Rich Shaw Inc. would require a higher required return due to its higher systematic risk.

  2. Melon Inc.: Melon Inc. has a higher proportion of unsystematic risk (60%) compared to Rich Shaw Inc. Unsystematic risk is specific to individual stocks and can be reduced through diversification. Since Melon Inc. has a higher unsystematic risk component, it implies that the stock's returns are more affected by company-specific factors rather than overall market movements. Therefore, Melon Inc. would require a lower required return due to its higher unsystematic risk.

Based on the above analysis, we can conclude that the Rich Shaw stock (Rich Shaw Inc.) would have a higher required return compared to the Melon stock (Melon Inc.). Therefore, the correct answer is:

A. a higher required return.

Prev Question Next Question