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Chapter 17 - Financial Economics
CHAPTER SEVENTEEN
FINANCIAL ECONOMICS
CHAPTER OVERVIEW
This chapter provides an introduction to financial economics. It begins by distinguishing between
economic investment and financial investment. Next the calculation and use of present value in decision-
making is presented. An overview of stocks, bonds, and mutual funds is provided, followed by an
explanation of the why investors choose different assets and why those assets produce different returns.
Portfolio diversification and the relationship between risk and return are explained. Finally, a discussion
of arbitrage demonstrates why rates of return change and why it is hard even for professional investors to
“beat the market.”
WHAT’S NEW
There are major revisions to the Learning Objectives.
There are five more Quick Reviews to help the students retain the appropriate information.
All relevant tables and graphs have been updated with current data.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:
1. Distinguish between economic investment and financial investment.
2. Explain the concept of present value.
3. Describe and calculate compound interest.
4. Calculate the present value of a future amount of money, and use that information to make a
financial decision.
5. Explain how present value calculations can be applied to lottery payouts and sports contracts.
6. Define and explain the differences between stocks, bonds, and mutual funds.
7. Explain the difference in structure and performance between actively managed and passively
managed funds.
8. Calculate investment returns from sale and/or rental of an asset.
9. Describe the relationship between the price of an asset and its rate of return.
10. Define arbitrage and explain how it equalizes rates of return among assets with similar levels of
risk.
11. Explain how portfolio diversification is used to reduce investment risk.
12. Describe the difference between diversifiable and non-diversifiable risk.
13. Explain how expected rates of return and beta statistics can be used to make investment decisions.
14. Describe the relationship between risk levels and average expected rates of return.
15. Define the risk-free rate of return and explain why time preference makes the rate greater than zero.
16. Graph and explain the Securities Market Line, including how monetary policy can alter the line.
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Chapter 17 - Financial Economics
17. Explain the relationship between ethical investing and rates of return.
18. Define and identify terms and concepts listed at the end of the chapter.
COMMENTS AND TEACHING SUGGESTIONS
1. The Wall Street Journal and similar publications present articles daily that are devoted to the
investment decision-making issues addressed in this chapter. Pedagogical opportunities from these
publications are numerous. Students might be asked to find and compare the different market
interest rates, to track a stock (or sector), or to consider (and write about) how a story about a
company may affect investor perceptions about risk and expected rates of return.
2. Investment games are a great way to stimulate interest in this topic. One version is to have
students, individually or in groups, construct a portfolio of a given number of stocks (four is
common). Have them compete against you, the “dartboard” randomly picking stocks, and/or an
index like the S&P 500. Variations might include giving groups a fixed amount of play money to
constrain their stock picks and put more complexity in their portfolio, or to allow them to invest in
other assets where the rate of return can be easily calculated (e.g. bonds or mutual funds).
3. Speakers on investment topics should be relatively abundant in the surrounding community, and
may help students forge a connection for a later internship or job opportunity. Within the college,
the chief financial officer (or equivalent) could speak about how the endowment is structured, and
how assets in the endowment are chosen to maximize return, provide stable revenue streams, and
manage risk.
4. Impress upon students the magic of compound interest and the importance of starting early. Give
students plenty of practice in calculating present values, compound interest, etc.
STUMBLING BLOCKS
Students will find that this chapter has a lot of relevance to their future, if not their current situation, so
stimulating interest should not be a problem. What may trip up students are the calculations,
especially if you ask them to solve for t (time) or i (interest rate) in the present value model. Some
students will require more help on this than others, and depending on your learning objectives for
students in this chapter, much practice may be necessary.
Although the distinction is clearly spelled out in the chapter, there may be confusion with the term
“investment.” Students will have heard all term (up to when the chapter begins) that in economics,
“investment” refers to “economic investment” – expenditures that add to the capital stock of a
nation. That use of the term is suspended for this chapter only, where “investment” will be used for
“financial investment,” as it is primarily by the general public. For students who have struggled to
this point to go from the commonly used definition to the economists’ definition of investment, this
deviation may be frustrating. For those who still haven’t got it, they may welcome not being
corrected on misuse of the terms for a chapter.
LECTURE NOTES
I. Learning objectives – After reading this chapter, students should be able to:
A. Define financial economics and distinguish between economic investment and financial
investment.
B. Explain the time value of money and how compound interest can be used to calculate the
present value of any future amount of money.
C. Indentify and distinguish between the most common financial investments: stocks, bonds,
and mutual funds.
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Chapter 17 - Financial Economics
D. Relate how percentage rates of return provide a common framework for comparing assets and
explain why asset prices and rates of return are inversely related.
E. Define and utilize the concept of arbitrage.
F. Describe how the word risk is used in financial economics and explain the difference between
diversifiable risk and non-diversifiable risk.
G. Convey why investment decisions are determined primarily by investment returns and non-
diversifiable risk and how investment returns compensate for being patient and for bearing
non-diversifiable risk.
H. Explain how the Security Market Line illustrates the compensation that investors receive for
time preference and non-diversifiable risk and why arbitrage will tend to move all assets onto
the Security Market Line.
II. Financial Investment
A. It is important to distinguish between two types of investment:
1. Economic investment – payments for new additions to the nation’s capital stock, whether
public (new roads and bridges) or private (new factories, homes, and equipment).
2. Financial investment – buying or building an asset in expectation of earning a financial
gain (new factories and homes, but also old buildings, plus stocks, bonds, and other
financial assets).
B. Economic investments are often also financial investments, but financial investment is
broader in that it includes transfers of ownership (e.g. buying stock) that don’t directly affect
the nation’s capital stock.
C. In everyday use (by noneconomists), financial investment is typically just referred to as
“investment.” (Subsequent uses of “investment” in the chapter are referring “financial
investment,” which is different from the rest of the book.
III. Present Value
A. Time-value of money means that money has greater value the earlier it’s received and a
person must be compensated if he has to wait to receive the money.
B. Present value measures the present day value, or current worth, of returns or costs expected to
arrive in the future. It is helpful in determining the appropriate price to pay for an asset.
C. Compound interest determines how quickly an interest-bearing investment increases in value.
1. Compounding refers to the process of paying interest not only on the original investment,
but also on previously received interest.
2. Example: $100 invested today at an 8% annual rate of interest will be worth $108 at the
end of one year. [$108 = $100 (1+.08)].
a. In the second year, interest will be paid on the accumulate amount of $108, so the
value of the asset at the end of second year will be $116.64 [$116.64 = $108 (1+.08)
= $100 (1+.08)2]
b. The value of this original $100 investment after t number of years can be found by
multiplying $100 times (1+.08)t. (Table 17.1)
c. The general formula: X dollars today = (1+i)t X dollars in t years. (Equation 1)
3. Dividing both sides of the compounding formula by (1+i)t reveals how much X dollars in
t years is worth today.
D. The Present Value Model
1. The present value of a future value of money is found with the formula:
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Chapter 17 - Financial Economics
X/(1+i)t dollars today = X dollars in t years. (Equation 2)
2. Equations 1 and 2 allow investors to convert present amounts of money into future
amounts and vice versa.
3. Finding the present value of the future payments from an asset allows an investor to find
the price that should be paid for an asset. Specifically, the asset’s price should exactly
equal the total present value of all of the asset’s future payments.
4. Example:
a. As illustrated in Table 17.1, $100 invested today at an 8% interest rate that is
compounded annually will be worth $370 in 17 years. Working backwards (dividing
$370 by (1+.08)17) reveals that $370 to be received 17 years from now is worth $100
today.
b. Potential buyers of this asset (that will pay $370 in 17 years) will not pay more than
$100, as they can earn that much in alternative investments. Likewise, sellers will
not accept less than $100 as they know that buyers will have to invest $100 in
comparable assets to generate that return. The present value of the asset ($100) thus
defines the price of the asset.
E. Applications of present value
1. Winners of large lottery payouts are often given the choice of receiving the money in one
lump some, or receiving a stream of payments over an extended period of time (20 to 30
years).
a. State lotteries are typically arranged to pay out winnings in equal installments over an
extended period of time. Winners motivated to receive their winnings sooner can
arrange a lump sum payment sooner than the scheduled payout.
b. The size of lump sum payment is based on the sum of the present values of the future
payments. This is determined by the size of the scheduled future payouts, when those
payments are due to be made, and the rate of interest.
c. In present value terms, winners of large lottery jackpots never receive the stated
amount of the jackpot!
2. Salary caps in professional sports result in deferred compensation for athletes.
a. Salary caps are intended to keep spending among teams comparable so that all teams
have the chance to compete for championships.
b. Multiple season contracts are common, and teams near their salary cap, yet wanting to
acquire more talent, may offer contracts that defer compensation to later years.
c. An economically rational athlete willing to defer compensation will require that the
future payments be higher so that the present value of their contract matches their
current market value.
IV. Some Popular Investments
A. There is a wide array of financial “instruments” in which one can invest. Though the range
of choices is vast and complex, all investments share these three features:
1. Investors are required to pay some market determined price to acquire them.
2. Owners of these investments are given the opportunity to receive future payments.
3. The future payments usually involve the risk of loss.
B. Stocks are ownership shares in a corporation.
1. Ownership of shares (as a percentage of the total number of shares) entitles the owner to
that percentage of votes at shareholder meetings, and that percentage of any future profit
distributions.
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Chapter 17 - Financial Economics
2. Corporations going bankrupt and forced to sell off assets must first pay creditors (those
owed money by the company), with any remaining distributed to shareholders based on
their percentage of ownership. Bankruptcy is the main risk faced by shareholders.
3. Because of the limited liability rule, the most shareholders can lose is what they paid for
their shares. They are not responsible for any remaining liabilities of the corporation.
4. Investors can profit from stock ownership in two ways:
a. Capital gains are earned when the stock is sold for more than what the buyer paid for
the shares.
b. Dividends are shares of the corporation’s profits.
C. Bonds are debt contracts issued by corporations and governments.
1. The bond investor loans money for a certain period of time. The bond issuer promises to
make payments over the period of the bond so that the investor receives back both the
initial investment and interest payment.
2. Investors can sell bonds to other investors; the price at which a bond will sell depends on
current rates of return on similar investments.
3. Default is the primary risk faced by bondholders. The risk of default varies according to
who issues the bond. The U.S. Federal government has never defaulted on bond
payments. Bonds issued by state and local governments carry some risk, but corporate
bonds (of which there are many types) tend to be the most risky.
D. Bonds are more predictable than stocks in making payments. Stocks historically generate
higher rates of return.
E. Mutual funds are a collection (portfolio) of stocks and/or bonds, purchased by pooling the
money of many investors.
1. There are more than 8000 mutual funds currently in the U.S. Table 17.2 shows the 10
largest (based on assets under management).
2. Some mutual funds focus narrowly on a particular sector (health care stocks, short-term
government bonds); others include a broader range of stocks and bonds.
3. Index funds are portfolios exactly matching an established stock or bond index (e.g. the
Standard and Poor’s 500 Index or Lehman 10-year Corporate Bond Index).
4. Funds may be actively managed or passively managed.
a. Actively managed funds have portfolio managers constantly buying and selling assets
in the fund to generate higher returns.
b. Assets in passively managed funds (index funds) are determined automatically by the
indexes to which they are tied.
5. At the end of 2012, U.S. households and nonprofit organizations held almost $5.3 trillion
in mutual funds (compared to a $15.7 trillion GDP for the U.S. in 2012).
F. Calculating investment returns
1. Investment returns can be calculated whether there is one future payment or many.
a. A single payment would occur from selling a previously purchased asset (home,
stock, rare comic book).
b. An asset that is rented (housing) will generate a series of payments.
2. Gains or losses are expressed as a percentage rate of return on the buying price.
a. Mathematically, the amount of gain or loss is divided by the purchase price.
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Chapter 17 - Financial Economics
b. Rates of return are often expressed in annual terms, so monthly rental payments
would be summed for the entire year and then divided by the purchase price of the
asset.
G. Asset prices and rates of return
1. An investment’s rate of return is inversely related to its price.
2. Example: A bond pays $24,000 in interest per year. If the investor pays $100,000 for the
bond, the rate of return will be 24 percent per year ($24,000/$100,000). If instead the
price was $200,000, the rate of return would only be 12 percent per year
($24,000/$200,000).
3. The reason for the inverse relationship is that there are upper limits (in dollar terms) to
what an asset can earn. If the maximum dollar return is fixed, a higher price must
necessarily result in a lower percentage rate of return.
V. Arbitrage
A. Arbitrage occurs when investors try to profit from differences in rates of return between
identical or nearly identical assets.
B. Investors will simultaneously sell the asset with the lower rate of return and buy the asset
with the higher rate of return.
C. As investors sell the asset with the lower rate of return, the asset’s price will fall, increasing
the rate of return. Likewise, as investors move to buy the asset with the higher rate of return,
its price will be driven up, and its rate of return will fall.
D. The arbitrage process will continue until rates of return on identical assets equalize, and it
generally happens quickly. (Key Question 6)
VI. Risk
A. Risk refers to the uncertainty of the size of future payments.
B. Diversification
1. The collection of investments owned by an investor is a portfolio.
2. Diversification is the strategy of owning many different investments as a means to reduce
the overall risk to the portfolio. (“Don’t put all of your eggs in one basket.”)
3. Poor performance by one or two investments can be offset by strong performances of
other investments.
4. Diversification reduces risk, but cannot eliminate it. Events such as recessions can
adversely affect most, if not all, investments in a portfolio.
C. Risk that can be reduced by diversification is known as “diversifiable risk” (or “idiosyncratic
risk”). Events that are bad for one part of the portfolio are offset by good effects for other
investments.
D. Risk that cannot be reduced by diversification is known as “non-diversifiable risk” (or
“systemic risk”).
1. Some events may push all investments in the same direction, and it is impossible to add
other investments to the portfolio that will offset negative effects.
2. Even though there is always some non-diversifiable risk, diversification is still the best
strategy for minimizing overall risk as much as possible. It is possible to eliminate all
diversifiable risk.
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Chapter 17 - Financial Economics
E. An investor with an already diversified portfolio can ignore the diversifiable risk of a new
investment and focus on comparing the non-diversifiable risk with the potential returns.
F. Comparing risky investments
1. The two most important factors in the investment decision are returns and (non-
diversifiable) risk.
2. Returns are typically measured as the average expected rate of return.
a. An investment’s average expected rate of return is the probability weighted average
of the investment’s possible future rates of return.
b. Each possible future rate of return of an asset is multiplied by the probability (as a
decimal) of that return occurring. Those amounts are then summed to find the
average for the investment.
c. Example: If rates of 11 percent per year and 15 percent per year are equally likely, the
average expected rate of return is 13 percent (= .5(11 percent) + .5(15 percent)).
d. Note that equal weights are a special case. If in the above example there was a 25
percent chance of earning 11 percent and a 75 percent chance of a 15 percent return,
the average expected rate of return would instead be 14 percent (= .25(11) + .75(15))
3. Beta is a statistic commonly used as a relative measure of the non-diversifiable risk of an
investment.
a. Beta measures how the non-diversifiable risk of an asset or portfolio of assets
compares with the market portfolio.
i. The market portfolio includes every asset available in financial markets.
ii. Because it contains every asset, it is only exposed to non-diversifiable risk.
iii. The beta of the market portfolio is set equal to 1.0.
b. A beta value less than one indicates a less risky asset. More specifically, an asset
with a beta of 0.5 would indicate that the asset has half the non-diversifiable risk of
the market portfolio.
c. Beta values greater than one indicate higher levels of non-diversifiable risk. An asset
with a beta of 2.0 would be twice as risky as the market portfolio and four times as
risky as an asset with a beta of 0.5.
d. Betas can be calculated for portfolios as well as individual assets, so investors in
mutual funds can easily compare risk levels.
G. Relationship of risk and average expected rates
1. Investors dislike risk and must be compensated for taking greater risks with higher
average expected rates of return.
a. Investors will be less willing to pay for riskier assets, so the prices of those assets
will be lower than prices of less risky assets.
b. As demonstrate above, lower priced assets have higher rates of return.
c. Investor dislike of risk means that risk levels and average expected rates of return are
positively related.
2. The positive relationship between risk levels and average expected rates of return applies
to all assets.
3. Global Perspective 17.1 shows how risk levels vary across selected countries, based on
political, economic, and financial factors. Investing in assets in industrialized nations, particularly in
Europe, tend to be less risky than in developing countries, such as in Africa. Of the 140 countries ranked,
Somalia was rated as the most risky.
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Chapter 17 - Financial Economics
H. The risk-free rate of return
1. Short-term U.S. government bonds are considered to be risk-free.
2. Despite being risk-free, U.S. government bonds still pay a positive rate of return because
of time preference – peoples’ preference to consume in the present rather than the future.
3. The interest rate on short-term U.S. government bonds is referred to as the risk-free
interest rate.
a. The risk-free interest rate is compensation for time preference only, not for risk.
b. The Federal Reserve effectively determines the risk-free interest rate through open
market operations (See Chapter 16 for review). This means that the Fed has the
power to influence rates of return and prices of all assets.
VII. Security Market Line
A. The Security Market Line (SML) graphically portrays, across all assets, the relationship
between risk levels and average rates of return.
B. The model is based on the premise that an investment’s average expected rate of return is
based on two parts: compensation for time preference, and compensation for risk.
1. Average expected rate of return = Rate that compensates for time preference + Rate that
compensates for risk.
2. The risk-free interest rate is the rate paid on short-term government bonds (if).
3. The rate that compensates for risk is the risk premium, which varies directly with the
non-diversifiable risk of the asset.
C. Figure 17.1 shows the Security Market Line.
1. The horizontal axis measures risk levels (betas); the vertical axis measures average
expected rates of return.
2. The risk-free interest rate is the vertical intercept of the SML. It is determined by Federal
Reserve policy.
3. Short-term U.S. government bonds are depicted by a point at the vertical intercept (beta =
0); the market portfolio is shown as a point on the SML where beta = 1.0.
4. The vertical distance between the risk-free interest rate and the average expected rate of
return of the market portfolio is the risk premium for the market portfolio.
5. The various points along the SML represent assets with different risk levels (betas), and
their respective rates of return.
6. The slope of the SML depends on investor attitudes about risk, and how much
compensation they require to accept it. The more investors dislike risk, the steeper the
SML. A horizontal SML would imply that investors have no concern about risk and
require no compensation for facing it.
D. If an investor knows the beta of a particular asset or portfolio, the SML allows the investor to
see what average expected rate or return that asset should earn. (Figure 17.2)
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Chapter 17 - Financial Economics
E. Every asset should fall on the SML, but if an asset moves off the SML (earning a rate of
return higher or lower than the averaged expected rate of return for that class of asset),
arbitrage will return it to the line. (Figure 17.3)
1. An asset earning above the average expected rate of return (point A on Fig. 17.3) will see
investors trying to buy more of that asset. The increased demand will raise the price of
the asset and lower its expected rate of return until it is in line with the SML.
2. Investors owning asset C on Figure 17.3 will want to get rid of the asset as it is earning
less than the average expected rate of return. This will cause the price of C to drop,
raising its expected rate of return until it is equal to others of the same risk level.
F. Consider This … Ponzi Schemes
1. With Ponzi schemes investors are unknowingly paid returns out of monies received from
new investors.
2. Effective Ponzi schemes attract new investors with promises of high returns and low risk,
and much of the investment money is kept by the promoter of the scheme.
3. To remove the threat of arbitrage the promoter insists that the investment opportunity is
only available to him. Participants in Ponzi schemes unknowingly grow the scheme by
recommending investments by their family and friends.
4. The largest Ponzi scheme was run by Bernie Madoff. When the scheme was uncovered,
investors had lost $13 billion in investment funds and $65 billion in returns.
VIII. Security Market Line: Applications
A. An increase in the risk-free rate
1. The Federal Reserve can increase the risk-free interest rate by selling government bonds
in the open market (restrictive monetary policy).
2. An increase in the risk-free rate will raise the intercept and cause a parallel shift of the
SML.
3. As the risk-free interest rate rises, so do the average expected rates of return of all other
assets. (Figure 17.4)
a. All assets compete for investors’ money, and investors are attracted to low-risk,
high return assets.
b. As the risk-free rate rises, government bonds become more attractive. As
investors sell their riskier assets to buy bonds, prices of the sold assets fall,
increasing their rates of return.
4. By shifting the SML the Federal Reserve can affect all asset prices, which explains why
investors watch closely decisions of the Fed.
B. The Security Market Line During the Great Recession
1. The Fed decreased interest rates, causing SML for the economy to shift down.
2. Despite lower risk-free interest rates, stock prices didn’t increase because of people’s
fear of financial instability.
3. With the Fed’s reduction in interest rates and decreased attraction to risk:
a. SML intercept fell
b. SML became steeper
4. The increase in the slope of the SML was stronger causing investors to sell stocks,
decreasing stock prices.
IX. LAST WORD: Why Do Index Funds Beat Actively Managed Funds?
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Chapter 17 - Financial Economics
A. Mutual fund investors can choose between actively managed funds, with professional
managers constantly pursuing higher returns, or passively managed funds, where portfolios
match the index they mimic.
B. Though one might expect active management to generate greater returns, passively managed
index funds have outperformed actively managed funds in recent years, by about 1 percent
per year. This has occurred for two main reasons:
1. Arbitrage limits the ability of active fund management to generate higher returns for an
extended period of time.
2. Actively managed funds charge higher fees, as they incur greater costs in the ongoing
buying and selling of assets. These additional costs, which lower the rates of return for
investors in actively managed funds, account for the 1 percent per year difference.
C. Why do actively managed funds still exist?
1. Index funds are boring and guaranteed to be average.
2. Actively managed funds are the only way to beat the average.
QUIZ
1. Present value is best defined as the:
A. worth today of future expected returns or costs.
B. worth in the future of a current flow of returns or costs.
C. current worth of a financial asset purchased in the past.
D. expected future value of a financial asset purchased today.
2. Suppose that Betty takes out a loan for $300 at an annually compounded interest rate of 6 percent
to be repaid after 5 years. How much will be required to pay off the loan at the end of the 5 years?
A. $401.47
B. $390
C. $393.54
D. $408.75
3. One statistic that quantifies the risk of an investment is:
A. alpha.
B. beta.
C. gamma.
D. the average expected rate of return.
4. Riskier investments tend to sell for:
A. lower prices so they provide a higher expected rate of return to compensate for risk.
B. higher prices so they provide a higher expected rate of return to compensate for risk.
C. higher prices; that is why they are considered to be riskier.
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Chapter 17 - Financial Economics
D. prices directly correlated with expected rates of return.
5. The limited liability rule means that if a corporation goes bankrupt:
A. Shareholders are responsible for all the debts of the firm
B. Bondholders are responsible for all the debts of the firm
C. Shareholders only lose the amount they invested
D. Bondholders only lose the face value of the bond
6. A bond of $1000 offers to pay $50 annually. What is the percentage rate of return?
A. 5 percent
B. 10 percent
C. 20 percent
D. 50 percent
7. An investor wants to invest in the oil industry, but does not know which major companies will
produce the greatest return. As a result, the investor buys shares in several oil companies. By
buying several companies to reduce risk, the investor is seeking to lower:
A. Systemic risk
B. The risk premium
C. Diversifiable risk
D. Nondiversifiable risk
8. If an investment is 70 percent likely to return 10 percent per year and 30 percent likely to return
15 percent a year, then its average expected rate of return is:
A. 10.5 percent
B. 11.0 percent
C. 11.5 percent
D. 12.5 percent
9. The Securities Market line (SML) shows how the average expected rates of return on assets vary
by:
A. Stock price
B. Risk level
C. Dividend payment
D. Time preference
10. The Securities Market Line (SML) is:
A. Upsloping, indicating that the average expected return increases as the risk level increases
B. Upsloping, indicating that the average expected return decreases as the risk level increases
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C. Downsloping, indicating that the average expected return decreases as the risk level increases
D. Downsloping, indicating that the average expected return increases as the risk level decreases
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