Practice Question
Match the following statements to true or false:
A) The market risk premium is only the percentage of the portfolio consisting of risk-free assets divided by the percentage of the portfolio consisting of risky assets.
B) The market risk premium is the slope of the security market line and the difference between the expected rate of return from the market portfolio (ERM) and the expected rate of return from the risk-free asset (RF).
C) Stocks with the same total risk can have different betas.
D) The slope of the capital market line (CML) is the market risk premium (ERM – RF).
E) The slope of the security market line (SML) will increase if the risk-free rate increases.
Answer +
Correct Answer:
A. FALSE – B. TRUE – C. TRUE – D. FALSE – E. FALSE
A. FALSE – B. TRUE – C. TRUE – D. FALSE – E. FALSE
Explanation +
- A) False. The market risk premium is the difference between the expected return on the market portfolio and the risk-free rate. It is not derived from the ratio of risk-free to risky portfolio weights.
- B) True. The slope of the Security Market Line (SML) is indeed the market risk premium (ERM – RF). It represents the additional return required per unit of beta risk.
- C) True. Beta only measures systematic (market) risk. Total risk includes both systematic and unsystematic risk—so two stocks with the same total risk may have very different betas depending on how much market-related exposure they have.
- D) False. The slope of the Capital Market Line (CML) is the Sharpe Ratio: (ERM – RF) / σmarket, not just the raw difference (ERM – RF).
- E) False. The slope of the SML is the market risk premium. If RF increases and ERM remains constant, the market risk premium actually decreases, causing the SML to flatten.