Question

8. Changes to the security market line Aa Aa E 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 0.0 0.5 1.0 1.5 2.0 RISK (Beta) Value CAPM Elements Risk-free rate (TRF) Market risk premium (RPM) Happy Corp. stock's beta Required rate of return on 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 suggested by this analyst's prediction. Happy Corp.'s new required rate of return is Tool tip: Mouse over the points on the graph to see their coordinates.

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Answer:

From the given graph, Risk-free rate = 4% Market Risk-Premium = Market Return - Risk-Free Rate = 10% - 4% = 6% Beta = 0.6 Required Rate = 7.6% (4% + .6 x 6%) New Required Rate = 6% +0.6 x 6% = 9.6% Steeper SML would be a Horizontal Line. The slope of the SML changes increases with the risk aversion of the investor. In case the investor is not at all risk averse, he will be risk indifferent to risk. In that case, there will be no risk premium and the SML shall be a horizontal line.