Risk and Rates of Return: Security Market Line The security market line (SML) is

Question

Risk and Rates of Return: Security Market Line

The security market line (SML) is an equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities. The SML equation is given below:

If a stock's expected return plots on or above the SML, then the stock's return is -Select-insufficientsufficientCorrect 1 of Item 1 to compensate the investor for risk. If a stock's expected return plots below the SML, the stock's return is -Select-insufficientsufficientCorrect 2 of Item 1 to compensate the investor for risk.

The SML line can change due to expected inflation and risk aversion. If inflation changes, then the SML plotted on a graph will shift up or down parallel to the old SML. If risk aversion changes, then the SML plotted on a graph will rotate up or down becoming more or less steep if investors become more or less risk averse. A firm can influence market risk (hence its beta coefficient) through changes in the composition of its assets and through changes in the amount of debt it uses.

Quantitative Problem: You are given the following information for Wine and Cork Enterprises (WCE):

rRF = 2%; rM = 7%; RPM = 5%, and beta = 1.3

What is WCE's required rate of return? Round your answer to 2 decimal places. Do not round intermediate calculations.
%

If inflation increases by 1% but there is no change in investors' risk aversion, what is WCE's required rate of return now? Round your answer to two decimal places. Do not round intermediate calculations.
%

Assume now that there is no change in inflation, but risk aversion increases by 1%. What is WCE's required rate of return now? Round your answer to two decimal places. Do not round intermediate calculations.
%

If inflation increases by 1% and risk aversion increases by 1%, what is WCE's required rate of return now? Round your answer to two decimal places. Do not round intermediate calculations.
%

Explanation / Answer

Risk free rate = 2%

Market Return = 10%

Risk Premium = 5%

Beta = 1.30

a.

Required rate of return = 2% + (5% × 1.30)

= 2% + 6.50%

= 8.50%

Required rate of return for WCE is 8.50%.

b.

If inflation rate increase by 1% then risk-Free rate increase by 1%. So, new risk-free rate would be 3% and risk premium of investor remains same.

So, New Required rate of return = 3% + (5% × 1.30)

   = 3% + 6.50%

  = 9.50%

New Required rate of return for WCE is 9.50%.

c.

If risk Aversion increase by 1% then risk premium increase by 1%. So, new risk premium would be 6%.

So, New Required rate of return = 2% + (6% × 1.30)

     = 2% + 7.80%

      = 9.80%

New Required rate of return for WCE is 9.80%.

d.

If inflation rate increase by 1% then risk-Free rate increase by 1%. So, new risk-free rate would be 3%. again, risk Aversion increase by 1% then risk premium will increase by 1%. So, new risk premium would be 6%

So, New Required rate of return = 3% + (6% × 1.30)

  = 3% + 7.80%

= 10.80%

New Required rate of return for WCE is 10.80%.

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