CAPM implies that if stock A has higher volatility than stock B, then stock A should have a higher expected return than stock B, as a form of risk compensation.

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The statement to evaluate is: CAPM implies that if stock A has higher volatility than stock B, then stock A should have a higher expected return than stock B, as a form of risk compensation.
Option 1: True. This claim suggests a direct, one-to-one relationship where greater volatility (risk) automatically yields higher expected return under CAPM. However, CAPM does not tie expected return to total or realized volatility alone; it ties expected return to systematic risk, measured by beta, which reflects sensitivity to market movements. Two assets can have different total volatilities but similar betas, hence similar expected returns. Therefore, labeling the statement as true would misstate CAPM’s core idea that only market-wide risk (beta) is priced, not all volatility.
Option 2: False. This reflects the CAPM nuance correctly: higher total volatility does not guarantee a higher expected return unless that higher risk is due to higher systematic risk (beta). Unsystematic risk is diversifiable and not compensated in CAPM, and two assets with higher volatility could have the same or even lower beta than another asset, leading to comparable or lower expected returns. The risk/return trade-off in CAPM is about market risk, not total volatility alone, which makes the blanket assertion incorrect.
In summary, the logic in the statement conflates total volatility with the CAPM-priced risk, which specifically concerns beta (systematic risk). Since higher volatility does not necessarily translate into higher beta, the proposition as a whole is not consistent with CAPM's pricing of risk. Therefore, the correct choice is the second option, False.

COEC_V 371 001 002 2025W1 2025W1 COEC 371 Final Exam Dec 16 - Requires Respondus LockDown Browser

CAPM implies that if stock A has higher volatility than stock B, then stock A should have a higher expected return than stock B, as a form of risk compensation.

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