Understanding CAPM and the Security Market Line, part 3. If the risk free rate R

Question

Understanding CAPM and the Security Market Line, part 3. If the risk free rate Rf =5%, the return on the market is Rm = 11%, and Beta for Stock i = 1.3, what is the expected return of E(Ri)IF investors express an increase in risk aversion that would cause Rm to increase by 3 percentage points, while Rf remains unchanged (Hint: This actually happened after the 2008 global economic weakening; investors lost money and were reluctant to reinvest in stocks, so they demanded higher returns when they did re-invest in stocks and eventually stocks rebounded, but many investors missed the rebound opportunities because their level of risk aversion was so high.)

Explanation / Answer

E(Ri) as per CAPM = Rf + beta*(Rm - Rf)

E(Ri) before increase in risk aversion = 5% + 1.3*(11% - 5%) = 12.8%

If risk aversion increases, the new level of Rm = 11%+0.03% = 11.03%
E(Ri) with increased risk aversion = 5% + 1.3*(11.03% - 5%) =12.839%

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