Question

In Chapter 7, we saw that if the market interest rate, rd, for a given bond increased, the price of the bond would decline. Applying this same logic to stocks, explain

(a) how a decrease in risk aversion would affect stocks’ prices and earned rates of return,

(b) how this would affect risk premiums as measured by the historical difference between returns on stocks and returns on bonds, and

(c) what the implications of this would be for the use of historical risk premiums when applying the SML equation.

Answer 1

a. A decrease in risk aversion will decrease the return an investor will require on stocks. Thus, prices on stocks will increase because the cost of equity will decline.

b. With a decline in risk aversion, the risk premium will decline as compared to the historical difference between returns on stocks and bonds.

c. The implication of using the SML equation with historical risk premiums (which would be higher than the "current" risk premium) is that the CAPM estimated required return would actually be higher than what would be reflected if the more current risk premium were used.