Question

Shifts in the security market line   Assume that the​ risk-free rate, Upper R Subscript Upper F​, is currently 9​%, the market​ return, r Subscript m​, is 13 %​, and asset A has a​ beta, b Subscript Upper A​, of 1.39. a.  Use CAPM to estimate the required​ return, r Subscript Upper A​, on asset A. Which of the following graphs represents the security market line​ (SML) and the required return for asset​ A? b.  Assume that as a result of recent economic​ events, inflationary expectations have declined by 2​%, lowering Upper R Subscript Upper F and r Subscript m to 7​% and 11​%, respectively. Which of the following graphs represents the new SML and shows the new required return for asset​ A? c.  Assume that as a result of recent​ events, investors have become more risk​ averse, causing the market return to rise by 1 %​, to 14​%. Ignoring the shift in part b​, which of the following graphs shows the new SML and the new required return for asset​ A?

Answer 1

Below is the solution, however graphs required to answer the remaining part of the question.

According to CAPM, Required rate of return is calculated using the below formula:

rA = Rf+β(Rm-Rf),

where :

rA = Required return on asset

Rf = Risk free rate of return

β = Beta of the security

Rm = Return on market securities

Solution (A): In the present case, Rf = 9%, Rm = 13%, β = 1.39

Therefore, rA = 9+1.39(13-9) = 14.56%

Solution (B): In the present case, Rf = 7%, Rm = 11%, β = 1.39

Therefore, rA = 7+1.39(11-7) = 12.56%

Solution (C): In the present case, Rf = 9%, Rm = 14%, β = 1.39

Therefore, rA = 9+1.39(14-9) = 15.95%

Hope the above solution helps.