Question
Consider the following two assets:
Asset
Expected Return
Beta
X
5.8%
0.8
Y
14.2%
1.8
If the risk free rate is 1%, what will happen to the prices of assets X and Y in an efficient market?
Multiple choice question.
Asset Y's price will rise and Asset X's price will fall
There is no way of knowing what will happen - efficient markets have no implications for the relationship between Asset X and Asset Y.
Asset X's price will rise and Asset Y's price will fall
Asset
Expected Return
Beta
X
5.8%
0.8
Y
14.2%
1.8
If the risk free rate is 1%, what will happen to the prices of assets X and Y in an efficient market?
Multiple choice question.
Asset Y's price will rise and Asset X's price will fall
There is no way of knowing what will happen - efficient markets have no implications for the relationship between Asset X and Asset Y.
Asset X's price will rise and Asset Y's price will fall
Answers
GPT-4o mini
To determine what will happen to the prices of assets X and Y in an efficient market, we can evaluate if either of the assets is underpriced or overpriced relative to their expected return and risk (beta).
In an efficient market, asset prices tend to adjust to reflect their risk and expected returns. We can compare the expected returns on the assets with what they should be given their betas and the risk-free rate.
The Capital Asset Pricing Model (CAPM) formula is used to estimate the expected return of an asset based on its beta:
\[ \text{Expected Return} = \text{Risk-Free Rate} + \beta \times (\text{Market Return} - \text{Risk-Free Rate}) \]
However, we don't have the market return in this case, but we can still understand the relative performance of the assets compared to the risk-free rate. We also lack specific market return data but can discuss the relative positioning of the two assets based on their betas and expected returns.
1. **Asset X:**
- Expected Return: 5.8%
- Beta: 0.8
2. **Asset Y:**
- Expected Return: 14.2%
- Beta: 1.8
First, let's analyze Asset X:
- The expected return of 5.8% is higher than the risk-free rate of 1%, but since it has a beta of 0.8, we can infer it carries lower risk compared to the market.
Next, analyze Asset Y:
- The expected return of 14.2% is significantly higher than the risk-free rate but comes with a higher beta of 1.8, suggesting it carries more risk but also offers a much higher potential return.
In an efficient market:
- If investors are demanding higher returns for higher risk and given Asset Y has a much higher expected return for its higher risk (as indicated by its higher beta), Asset Y could likely be more attractive to investors.
- Conversely, if Asset X's return is relatively lower for its risk profile, it might be perceived as overpriced compared to the potential return available from Asset Y.
Based on this understanding, we can conclude:
- Asset Y's price will likely rise as investors will demand more of it due to its attractive higher return per risk unit.
- Asset X's price will likely fall as it is less attractive in comparison.
The correct answer is:
**Asset Y's price will rise and Asset X's price will fall.**
In an efficient market, asset prices tend to adjust to reflect their risk and expected returns. We can compare the expected returns on the assets with what they should be given their betas and the risk-free rate.
The Capital Asset Pricing Model (CAPM) formula is used to estimate the expected return of an asset based on its beta:
\[ \text{Expected Return} = \text{Risk-Free Rate} + \beta \times (\text{Market Return} - \text{Risk-Free Rate}) \]
However, we don't have the market return in this case, but we can still understand the relative performance of the assets compared to the risk-free rate. We also lack specific market return data but can discuss the relative positioning of the two assets based on their betas and expected returns.
1. **Asset X:**
- Expected Return: 5.8%
- Beta: 0.8
2. **Asset Y:**
- Expected Return: 14.2%
- Beta: 1.8
First, let's analyze Asset X:
- The expected return of 5.8% is higher than the risk-free rate of 1%, but since it has a beta of 0.8, we can infer it carries lower risk compared to the market.
Next, analyze Asset Y:
- The expected return of 14.2% is significantly higher than the risk-free rate but comes with a higher beta of 1.8, suggesting it carries more risk but also offers a much higher potential return.
In an efficient market:
- If investors are demanding higher returns for higher risk and given Asset Y has a much higher expected return for its higher risk (as indicated by its higher beta), Asset Y could likely be more attractive to investors.
- Conversely, if Asset X's return is relatively lower for its risk profile, it might be perceived as overpriced compared to the potential return available from Asset Y.
Based on this understanding, we can conclude:
- Asset Y's price will likely rise as investors will demand more of it due to its attractive higher return per risk unit.
- Asset X's price will likely fall as it is less attractive in comparison.
The correct answer is:
**Asset Y's price will rise and Asset X's price will fall.**