The current risk-free rate of interest is 6%, and investors require a risk premi

Question

The current risk-free rate of interest is 6%, and investors require a risk premium of 5% for holding the market portfolio. An analyst believes that expected inflation will fall by 2 percentage points, but that will have no effect on the market risk premium. Use the graph below to plot the current Security Market Line (SML) and the new SML based upon this analyst's expectations about inflation. REQUIRED RATE OF RETURN 1%) 20 18 16 14 12 10 Slope - Y Intercept 17 New SML 1.0 2.0 RISK [Betal 0.0 0.5 1,5

Explanation / Answer

a)High beta stocks are most risky investment.so high beta stock is most affected by risk aversion.

correct option is"B"

b)Required return =Risk free rate +(beta*market risk premium)

9.4% = 5+(beta *4)

beta* 4 = 4.4

beta = 4.4/4

     =1.1

correct option is "A" =1.100

c)overall beta of old stock before new is added = Overall beta - weighted average beta of new stock

                                                                = 1.1 - ( .90*.20)

                                                                 = .92

so If weights are .20 , the overall beta of old stock = .92 , so if weights are .25 (1/4) , portfolio beta when new stock is not added = .92*.25/.20

                      = 1.150

correct option is "A" =1.150

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