Question

Assume that the risk-free rate, RF , is currently 8%; the market return, rm, is 12%; and asset A has a beta, of 1.10.

a. Draw the security market line (SML)

b. Use the CAPM to calculate the required return on asset A, and depict asset A’s beta and required return on the SML drawn in part a.

c. Assume that as a result of recent economic events, inflationary expectations have declined by 2%, lowering RF and RM to 6% and 10%, respectively. Draw the new SML on the axes in part a, and calculate and show the new required return for asset A.

d. Assume that as a result of recent events, investors have become more risk averse, causing the market return to rise by 1%, to 13%. Ignoring the shift in part c, draw the new SML on the same set of axes that you used before, and calculate and show the new required return for asset A.

e. From the previous changes, what conclusions can be drawn about the impact of (1) decreased inflationary expectations and (2) increased risk aversion on the required returns of risky assets?

Answer 1

First four parts have been covered below:

Part a)  

Part B) Let the required rate of return on Asset A be Re

Now using CAPM Equation =>  Re= RF + Beta(RM-RF) where RF is the risk-free rate and RM is Market Return

Now substituting the value in CAPM Equation

=> Re = 8 % + 1.1( 12% - 8 %)

=> Re = 8 % + 4.4 % = 12.2%

Thus Requried return on Asset A is 12.2 %

Part C) Inflationary expectation

Now rf = 6 % and RM = 12 %

New required rate of return is Re' = 6 % + 1.1 (12%- 6 %) = 12.6 %

Part 4 ) CASE: More Risk-Averse

New RM = 13 %

RF = 8 %

Beta of Asset A = 1.1

Using CAPM, Required rate of return, Re ''= 8 % + 1.1(13% - 8 %) = 13.5 %