I need expert help on SML and Changes in the Market Thanks so much!!! 8. The SML

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I need expert help on SML and Changes in the Market

Thanks so much!!!

8. The SML and changes in the market risk premium Aa Aa An analyst believes investors' attitudes toward risk will change, and thinks the market risk premium will increase from 5% to 8%. The risk-free rate is currently 5.0% and will remain unchanged. Use the graph below to plot the current SML and the new SML if this analyst's beliefs turn out to be right. REQUIRED RATE OF RETURN 1%) 20 18 16 14 12 10 Current SML New SML 0.0 0.5 1.0 1.5 2.0 RISK (Beta Help Clear All Which kind of stock is most affected by an increase in the market risk premium? (In other words, which stocks see the biggest change in their expected returns?) O High-beta stocks O Medium-beta stocks O All stocks are affected the same, regardless of beta Low-beta stocks

Explanation / Answer

Expected return of stock = Rf + beta*(Rm-Rf)

= 5% + beta*(Rm-Rf)

So if risk premium increases all stocks regardless of beta will be affected. So, option C is correct.

Lets check

if risk premium is 5% and beta is 0.5 expected return is 7.5%

If risk premium is 8% and beta is 0.5 expected return is 9%

If risk premium is 5% and beta is 0.8 expected return is 9%

If risk premium is 10% and beta is 0.6 expected return is 11%

From the above illustrations expected returns of stock changes due to increase in risk premium regardless of beta

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