Question

The risk free rate on a stock is 3%, the required rate in the market is 7%, and the beta is 1.6. This is the original position. Calculate the required rate of return, r.

2 points, show work

Based on the above, now assume that inflation is expected to increase by 2%. Calculate the required rate of return. 2 points, show work

What happens to the SML? Circle one: 1 point

Shifts Up or Shifts Down or Pivots Up or Pivots Down

What happens to the slope? Circle one: 1 point

Slope remains the same or Slope gets steeper or Slope gets flatter

Now assume that inflation is expected to decrease by 1%. Calculate the required rate of return.

2 points, show work

What happens to the SML? Circle one: 1 point

Shifts Up or Shifts Down or Pivots Up or Pivots Down

What happens to the slope? Circle one: 1 point

Slope remains the same or Slope gets steeper or Slope gets flatter

Answer 1

Q1a) Expected return = Risk free rate + beta (market return - risk free rate)

= 3% + 1.6 ( 7% - 3%)

= 3% + 1.6 (4%)

= 3% + 6.4%

= 9.4%

b) If inflation increases by 2%

Increase in inflation will increase risk free rate

Risk free rate = 3% + 2% = 5%

Market return = 7% + 2% = 9%

Expected return= risk free rate + beta ( market return - risk free rate)

= 5% + 1.6 (9% - 5%)

= 5% + 1.6 (4%)

= 5% + 6.4%

= 11.4%

An increase in inflation rate causes a parallel upward shift in the SML.

The slope of the SML remains same. This is because the slope is denoted by market risk premium ( marker return - risk free rate) and it remains unchanged.

C) If the inflation decreases by 1%

Risk free rate = 3% - 1% = 2%

Market return= 7% - 1% = 6%

Expected return= 2% + 1.6 ( 6% - 2%)

= 2% + 1.6 (4%)

= 2% + 6.4%

= 8.4%

The decrease in inflation rate causes SML to shift down.

The slope of the SML remains same due to unchanged market risk premium.