Question

Click here to read the eBook: The Relationship Between Risk and Rates of Return Problem Walk-Through REQUIRED RATE OF RETURN Suppose rRF = 8%, M = 10%, and b = 1.2. a. What is n, the required rate of return on Stock i? Round your answer to two decimal places. b. 1. Now suppose rrf increases to 9%. The slope of the SML remains constant. How would this affect rm and n? 1. Both rm and i will remain the same. II. Both rm and i will increase by 1%. III. I will remain the same and will increase by 1%. IV. I will increase by 1% and i will remain the same. V. Both rm and i will decrease by 1%.

Answer 1

(a): Required rate of return = rRF + bi*(rM – rRF)

= 8% + 1.2*(10%-8%)

= 10.40%

(b): The answer is option II i.e. both rM and ri will increase by 1%.

Explanation: The slope of the security market line is the market risk premium. If the market risk premium remains constant and the beta of the asset is unchanged, then the expected return will increase (or decrease) as much as the risk-free rate. Hence change in rM is 9%-8% = 1% and so ri will increase by 1% as well. rM will also increase by 1%.