Use the letter in front of the statement to answer the questions that follow. Re

Question

Use the letter in front of the statement to answer the questions that follow.

Read all the options first. The letter may be used to answer more than one question.

A. It increases by 3%

B. It decreases by 3%

C. It increases, but not proportionately

D. It decreases, but not proportionately

E. No change, remains the same

F. The SML shifts upward, but the slope remains constant

G. The SML shifts downward, but the slope remains constant

H. The SML pivots upward, and the slope becomes steeper

I. The SML pivots downward, and the slope becomes flatter

ASSUME THAT INFLATION IS EXPECTED TO INCREASE BY 3% THIS YEAR.

1. ___What would happen to the risk free rate, rrf

2. ___What would happen to the market rate, rm

3. ___What would happen to the required rate, r

4. ___What would happen to the slope of the SML

NOW ASSUME THAT INFLATION WIL NOT INCREASE, BUT INVESTORS BECOME MORE AVERSE TO RISK, THUS REQUIRING AN ADDITIONAL 3% RETURN ON THEIR INVESTMENTS.

5. ___What would happen to the risk free rate, rrf

6. ___What would happen to the market rate, rm

7. ___What would happen to the required rate, r

8. ___What would happen to the slope of the SML

There are three investment opportunities to consider. The forecasted risk-free rate is 9%, and the expected market rate is 13%. What is the required rate of return, r, for each of the following scenarios. Show Work. Assume investment A has a beta of .8 Assume investment B has a beta of 1.5 Assume investment C has a beta of 2.0 Which is the least risky investment? ____ Which is the most risky investment? __

Explanation / Answer

ASSUME THAT INFLATION IS EXPECTED TO INCREASE BY 3% THIS YEAR.

1. ___What would happen to the risk free rate, rrf => No change, remains the same

2. ___What would happen to the market rate, rm => No change, remains the same

3. ___What would happen to the required rate, r => It increases, but not proportionately

4. ___What would happen to the slope of the SML => The SML shifts upward, but the slope remains constant

NOW ASSUME THAT INFLATION WIL NOT INCREASE, BUT INVESTORS BECOME MORE AVERSE TO RISK, THUS REQUIRING AN ADDITIONAL 3% RETURN ON THEIR INVESTMENTS.

5. ___What would happen to the risk free rate, rrf => No change, remains the same

6. ___What would happen to the market rate, rm => It increases by 3%

7. ___What would happen to the required rate, r => It increases, but not proportionately

8. ___What would happen to the slope of the SML => The SML pivots upward, and the slope becomes steeper

"A has a beta of 0.8" is the least risky investment.

"C has a beta of 2.0" is the most risky investment.

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