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 8.0 4.0 0.0 0.5 1.0 1.5 2.0 RISK (Betal CAPM Elements Value Risk-free rate (FRF) 4.0% Market risk premium (RPM) 4.4% Happy Corp. stock's beta 2.2% Required rate of return on 7.6% Happy Corp. stock An analyst believes that inflation is going to increase by 2.0 % over the next year, while the market risk premium will be unchanged. The analyst uses the Capital Asset Pricing Model (CAPM). The following graph plots the current SML Calculate Happy Corp.'s new required return. Then, on the graph, use the green points (rectangle symbols) to plot the new SML cHgnested bu thic analuet's nrediction.

Answer 1

Solution:

1) Calculating the new expected return:

Expected return = Risk free rate + beta (Market risk premium)

we are given rf = 4% , market risk premium = 7.8% , beta =.6 , Inflation =2%

Due to the inflation the SML line would shift and the new real risk free rate = 4+2 = 6%

Expected return = 6% + .6 * ( 7.8%) {given: market risk premium remains unchanged}

= 6% + .6 (7.8%)

= 6% + 4.68% = 10.68%

2) SML with the shift accounting for the inflation

Resuied akctoM 12+ >Slope wilb Same as marat ns Ppem 6 SML lutfat Due to le 9se ৮ Rule (beta 4

3) As the SML helps us to find the risk aversion of the investor or it reflects the extent to which investors are averse to risk. The flatter the slope of the SML will be the less averse the investor will be or will have lower risk aversion.

So we can say, the flatter the slope of the SML the lower is the level of risk aversion.

4) As we concluded in the previous part that the SML reflects the level of risk aversion for an investor. So higher the risk aversion steeper would be the slope of the SML.

Our case is the one where the investor is non risk averse , so the options C and D gets cancelled out as both these options comes into picture only in case of a risk averse investor.

Slope of the SML is negative i.e. market risk premium is negative it can only happen when the rf > rm and we say the market highly underperforms the risk free securities (Inverted SML) so this option i.e. B) does not even apply for the nonrisk averse investor.

For a non risk averse investor the Slope of the SML would be a horizontal line hence does not account into any risk aversion.

Correct Option is A)

The new expected return would be 10.68%