Question

Explain how you would expect each of the following events to affect the security market line and the required rate of return on a given share (imagine that each event occurs independently of the others):

1. An increase in official short-term interest rates
2. A reduction in the degree of risk aversion in the market
3. An increase in the uncertainty of the share’s future prospects

Answer 1

Answer) a.) An increase in official short term interest rates generally leads to less borrowing because interest rates are higher,thereby decreasing investment and thus affecting demand,it will have a negative effect on most of security market and rate of return of shares,however one point is to be noted here that increase in long term interest rates will have a lot more negative effect.

b.) Risk aversion means tendency to avoid risk and play safer,in share market that would mean investing in more reliable companies with less return opportunity,if there is a deduction in risk aversion,people will take more risk,invest more in innovative but new inexperienced companies leading to a more opportunities for such companies and thereby increasing security market and share valuation and the rate of return generated from them.

c.) An increase in uncertainty in future prospects of share is always a bad sign,it will be difficult for current investors to keep their money invested in the share,let alone new investors which will lead to a lot of short selling of share leading a downfall in its price,thus rate of return in this case will go down drastically.

Answer is complete.Thank you!