Question

The following graph plots the current security market line (SML) and indicates the return that investors require from holding stock from Happy Corp. (HC). Based on the graph, complete the table that follows. REQUIRED RATE OF RETURN (Percent] 20.0 16.0 12.0 Return on HC's Stock 4.0 0.5 1.5 2.0 RISK (Beta) 0.0 1.0 CAPM Elements Value Risk-free rate (rRF) Market risk premium (RPM) Happy Corp. stock's beta Required rate of return on Happy Corp. stock

Answer 1

Based on the graph :

The risk free return is = 4%

From the graph, when the beta =1 , the market return is about 10%. So, Market risk premium = market return - risk free return = 10-4 = 6%

Market risk premium = 6%

Happy Corp Stock Beta = 0.6

Required return on happy corp. stock = 4 + 0.6*(10-4) = 7.6%

Next year when inflation increases by 2%, risk free return = 6% and Market risk premium = unchanged = 6%

So, Happy corp's new required rate of return = 6 + 0.6*6 = 9.6%

The new SML in green is as shown below:

Flatter the slope of the SML, the lower the level of risk aversion

which of the following best describes a shift in the SML caused by increased risk aversion?

Risk free rate will increase (Option A)