THE GRAPH POINT FOR RATE OF RETURN ON HC\'S STOCK: 1.2, 10.4 THE SECOND GRAPH IS
ID: 2788502 • Letter: T
Question
THE GRAPH POINT FOR RATE OF RETURN ON HC'S STOCK: 1.2, 10.4
THE SECOND GRAPH IS A SLOPE OF 4.5 AND A Y-INTERCEPT OF 5.
1ST POINT OF BLUE LINE IS AT 0.0, 5.0 AND 2ND POINT IS AT 2.0, 14.0
THANKS!
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. REQUIRED RATE OF RETURN (Percent 20.0 16.0 Return on HC's 120 8.0 0.5 1.0 1.5 2.0 RISK (Botal CAPM Elements Value Risk-free rate (rRF) Market risk premium (RPM) Happy Corp. stock's beta Required rate of return on Happy Corp. stock An analyst believes that inflation is going to increase by 2.0% 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. Cacate 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 Tool tip: Mouse over the points on the graph to see their coordinates. REQUIRED RATE OF RETURN Percent 20 New SML 16 12 0.0 0.8 1.2 16 20 RISK (Betal 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?) O All stocks affected the same, regardless of beta O High-beta stocks O Medium-beta stocks O Low-beta stocksExplanation / Answer
Risk free rate (rRF) = 5% (blue line (SML) intercept at y axis)
Market Risk premium (RPM) = (Expected market return – risk free rate)
Where Expected market return is 10.4% (the red dotted line intercepting at Y-axis)
Risk free rate is 5%
Therefore
Market Risk premium (RPM) = 10.4% -5% = 5.4%
Happy Crop. Stock’s beta = 1.2 (the red dotted line intercepting at X-axis)
Required rate of return of Happy Crop = risk free rate (rRF) + *(Expected market return – risk free rate)
= 5% + 1.2 * (10.4% - 5%)
= 5% + 1.2 *5.4% = 11.48%
If the inflation rate will increase 2%, the Security Market Line (SML) will shift above with 2% increase in risk free rate
The new risk free rate will be 5% +2% = 7%
Market Risk premium (RPM) and Happy Crop Stock’s beta will remain same
Happy Crop’s new required rate of return = risk free rate (rRF) + *(Expected market return – risk free rate)
= 7% + 1.2 * 5.4% = 13.48%
The SML helps determine the level of risk aversion among investors. The higher the level of risk aversion, the steeper the slope of SML
Which kind of stock is most affected by change in risk aversion are the high beta stocks because the required rate of return will change more with the degree of risk aversion.
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