PROBLEM: Graphical derivation and interpreting beta.

You are analyzing the performance of two stocks as shown in the following graphs: The first, shown in Panel A, is Cyclical Industries Incorporated. Cyclical Industries makes machine tools and other heavy equipment, the demand for which rises and falls closely with the overall state of the economy. The second stock, shown in Panel B, is Biotech Cures Corporation. Biotech Cures uses biotechnology to develop new pharmaceutical compounds to treat incurable diseases. Biotech's fortunes are driven largely by the success or failure of its scientists to discover new and effective drugs. Each data point on the graph shows the monthly return on the stock of interest and the

monthly return on the overall stock market. The lines drawn through the data points represent the characteristic lines for each security.

a. Which stock do you think has a higher standard deviation? Why?

b. Which stock do you think has a higher beta? Why?

c. If an investor was seeking to diversify the risk of their current portfolio, which stock would be preferred?

RESPONSE

a. Which stock do you think has a higher standard deviation? Why? (Select the best answer below.)

A. Biotech Cures stock has a higher standard deviation because its characteristic line has a higher slope.

B. Biotech Cures stock has a higher standard deviation because it has a larger range of returns.

C. Cyclical Industries stock has a higher standard deviation because it has a larger range of returns.

D. Cyclical Industries stock has a higher standard deviation because its characteristic line has a higher slope.

b. Which stock do you think has a higher beta? Why? (Select the best answer below.)

A. Biotech Cures stock has a higher beta because it has a larger range of returns.

B. Cyclical Industries stock has a higher beta because its characteristic line has a higher slope.

C. Biotech Cures stock has a higher beta because its characteristic line has a higher slope.

D. Cyclical Industries stock has a higher beta because it has a larger range of returns.

c. If an investor was seeking to diversify the risk of their current portfolio, which stock would be preferred? (Select the best answer below.)

A. Cyclical Industries Corporation.

B. Biotech Cures Corporation.