solution

The following graph plots the current security market line (SML) and indicates the return that investors require from holding stock from Happy Corp. (HC). Based on the graph, complete the table that follows:

00.51.01.52.020.016.012.08.04.00REQUIRED RATE OF RETURN (Percent)RISK (Beta)Return on HC’s Stock

CAPM Elements

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Value

Risk-free rate (rRFrRF)
Market risk premium (RPMRPM)
Happy Corp. stock’s beta
Required rate of return on Happy Corp. stock

An analyst believes that inflation is going to increase by 3.0% over the next year, while the market risk premium will be unchanged. The analyst uses the Capital Asset Pricing Model (CAPM). The following graph plots the current SML.

Calculate Happy Corp.’s new required return. Then, on the graph, use the green points (rectangle symbols) to plot the new SML suggested by this analyst’s prediction.

Happy Corp.’s new required rate of return is _______ .

New SML00.40.81.21.62.0201612840REQUIRED RATE OF RETURN (Percent)RISK (Beta)

The SML helps determine the level of risk aversion among investors. The higher the level of risk aversion, the ______ the slope of the SML.

Which kind of stock is most affected by changes in risk aversion? (In other words, which stocks see the biggest change in their required returns?)

Medium-beta stocks

All stocks affected the same, regardless of beta

Low-beta stocks

High-beta stocks

 
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