Question

Ch 08: Assignment - Risk and Rates of Return 11. Changes to the security market line 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) Return on HC's Stock RISK (Beta)

Answer 1

Read the values corresponding to beta 1. That will help you figure out the expected return from market.

When beta = 0, return = 4%, hence risk free rate = r_RF = 4.0%

When beta = 1, return = 10% = Rm, hence market risk premium = RP_M = Rm - r_RF = 10% - 4% = 6.0%

Beta = 0.6

Required rate of return = r_RF + beta x RP_M = = 4% + 0.6 x 6% = 7.6%

Risk free rate will also increase by 2% due to inflation, hence, new required rate of return = 7.6% + 2% = 9.6%

The slope of the SML reflects the degree of risk aversion in the economy. The higher the level of risk aversion to risk, the steeper the slope of SML.

The correct answer is the last option i.e. the SML would be a horizontal line.