The following graph plots the current SML and indicates the return that investor

Question

The following graph plots the current SML and indicates the return that investors require from holding stock from Happy Corp. (HC). Based on the graph, complete the table that follows. REQUIRED RATE OF RETURN (Percent 20.0 16.0 12.0 Return on HC's Stock 4.0 0.0 0.5 1.0 1.5 2.0 RISK (Beta) CAPM Elements Value Risk-free rate (rRF) Market risk premium (RPM) Happy Corp. stock's beta Required rate of return on Happy Corp. stock ! 0.6 An analyst believes that inflation is going to increase by 2.0% over the next year, while the market risk premium will

Explanation / Answer

1.) a) Risk free rate of return: At Risk free rate of return beta is 0. Inthe given graph, Return is 4% at beta 0 Hence; Risk free rate of return = 4% b) and c) Required rate of return as per CAPM = Risk free rate + Beta(Market Premium) Required rate of return at beta 0.6 is 8% as can be seen from Graph(Y axis) Therefore, 8% = 4% + 0.6(Market Premium) Market Premium = (8%-4%)/.6                                =6.67% 2.) Inflation will increase Risf Free rate by 2% New Required rate of return will be = 6%+0.6*6.67%                                                                   =10% 3.) The steeper the slope of SML, higher the level of risk aversion Slope of SML =( Market Return - Risk Free Rate of Return)/ Market Beta or,                   =Market Premium / Market Beta Market Beta is always 1 Therefore, Slope = Market Premium Slope of SML will be steeper if market premium would be high and consequently level of risk aversion will also be high. 4.) Answer: High Beta Stock Beta measure sensitivity of security return with the sensitivity of market return. Only high stock beta will be most affected by change in risk aversion or market sensitivity

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