Question

Ch. 8 Assessment ailings ReviewView AaBbCcD AaBbCoDdE AaBbCeDdI AaBbCcDdE Heading 1 Strong Subtitle Required rate ofretum for stock: 10% 8-3c Beta-Part 4 The return on a portfolio is 6%. The riskfree rate is 2% while the beta for the portfolio is 0.8. Calculate the market risk premium. 8-4a The Impact of Expected Inflation How does changing the inflation expectation affect the beta of the stock? 8-4b Change in Risk Aversion If the Security Market Line becomes steeper, how does that impact the required return for a stock and what is the impact to the stock's beta? (This is a two part question.) The steeper the slope of the line, the more average investor requires as compensation for bearing risk.

Answer 1

Question 8.3(c) - Part 4

Return on the portfolio, R_p = 6%

Risk free rate, R_f = 2%

Beta = 0.8

If R_mp denotes market risk premium, then as per CAPM

R_p = R_f + Beta x R_mp

Hence, 6% = 2% + 0.8 x R_mp

Hence, R_mp = (6% - 2%) / 0.8 = 5.00%

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Question - 8.4(a)

How does changing the inflation expectation affect the beta of the stock

There is no direct response to this question. Changing the inflation expectation can change the expected return on the stock and this may change the SML also. But this should not change the beta of the stock. Empirical studies have shown beta's neutrality to inflation expectation. Hence, changing the inflation expectation should not affect the beta of the stock.

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Question - 8.4(b)

If the Security Market Line becomes steeper, how does that impact the required return for a stock and what is the impact to the stock’s beta?

The slope of the Security Market Line is the market risk premium = R_M - R_F where R_M = Expected return from market and R_F is the risk free rate. Thus, the steeper the slope of the security market line, the higher will be the risk premium for all stocks, and hence the higher will be the required return. Thus, if the Security Market Line becomes steeper, the required return of a stock will increase.

In the SML equation, expected return is a dependent variable (y-axis) and Beta is the independent variab (x-asis). Hence, steepness or flatness of the Security Market Line will not have any impact on the stock's beta.