Question

In: Finance

10. Suppose rRF = 6%, rM = 11%, and bi = 1.3. 2. Now suppose rRF...

10. Suppose rRF = 6%, rM = 11%, and bi = 1.3.

2. Now suppose rRF decreases to 5%. The slope of the SML remains constant. How would this affect rM and ri?



-Select-IIIIIIIVVItem 3

  1. What is ri, the required rate of return on Stock i? Round your answer to two decimal places.
    %

  2. 1. Now suppose rRF increases to 7%. The slope of the SML remains constant. How would this affect rM and ri?

    1. Both rM and ri will remain the same.
    2. Both rM and ri will increase by 1%.
    3. rM will remain the same and ri will increase by 1%.
    4. rM will increase by 1% and ri will remain the same.
    5. Both rM and ri will decrease by 1%.


    -Select-IIIIIIIVVItem 2
    1. rM will decrease by 1% and ri will remain the same.
    2. rM will remain the same and ri will decrease by 1%.
    3. Both rM and ri will increase by 1%.
    4. Both rM and ri will remain the same.
    5. Both rM and ri will decrease by 1%.
  3. 1. Now assume that rRF remains at 6%, but rM increases to 12%. The slope of the SML does not remain constant. How would these changes affect ri? Round your answer to two decimal places.

    The new ri will be  %.

    2. Now assume that rRF remains at 6%, but rM falls to 10%. The slope of the SML does not remain constant. How would these changes affect ri? Round your answer to two decimal places.

    The new ri will be  %.

Solutions

Expert Solution

10. Suppose rRF = 6%, rM = 11%, and bi = 1.3.

2. Now suppose rRF decreases to 5%. The slope of the SML remains constant. How would this affect rM and ri?

Initially, ri = rRF + bi (rM - rRF) = 6% + 1.3 x (11% - 6%) = 12.50%

Now, rRF decreases to 5%.

The slope of the SML remains constant. This implies rM - rRF now = rM - 5% is same as before = 11% - 6% = 5%

Hence, rM = 5% + 5% = 10%

And ri = rRF + bi (rM - rRF) = 5% + 1.3 x (10% - 5%) = 11.50%

Hence, both rM and ri declines by 1% each.

=============================

-Select-IIIIIIIVVItem 3

  1. What is ri, the required rate of return on Stock i? Round your answer to two decimal places.

    Initially, ri = rRF + bi (rM - rRF) = 6% + 1.3 x (11% - 6%) = 12.50%

    Hence, your answer should be 12.50%

  2. 1. Now suppose rRF increases to 7%. The slope of the SML remains constant. How would this affect rM and ri?

Now, rRF increases to 7%.

The slope of the SML remains constant. This implies rM - rRF now = rM - 7% is same as before = 11% - 6% = 5%

Hence, rM = 7% + 5% = 12%

And ri = rRF + bi (rM - rRF) = 7% + 1.3 x (12% - 7%) = 13.50%

Hence, both rM and ri increases by 1% each.

Hence, the correct answer is option 2. Both rM and ri will increase by 1%

===========

-Select-IIIIIIIVVIte

  1. 1. Now assume that rRF remains at 6%, but rM increases to 12%. The slope of the SML does not remain constant. How would these changes affect ri? Round your answer to two decimal places.

    The new ri will be = ri = rRF + bi (rM - rRF) = 6% + 1.3 x (12% - 6%) = 13.80%

Hence, your answer should be 13.80%

  1. 2. Now assume that rRF remains at 6%, but rM falls to 10%. The slope of the SML does not remain constant. How would these changes affect ri? Round your answer to two decimal places.

    The new ri will be = ri = rRF + bi (rM - rRF) = 6% + 1.3 x (10% - 6%) = 11.20%

Hence, your answer should be 11.20%


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