Question

1. Assume risk-free rate is 3% and the market risk premium is 6%. If the overall market’s risk aversion increased so that the market risk premium increased to 7%, what will be the change to SML? Draw the original SML and the new SML in the same graph (not in two separate graphs) to show the change. If stock A’s beta is 1.2, what will be its required return before and after the change? Please show all the work needed to get the answer.

Answer 1

Before the change,

Required return= risk free rate + beta (market risk premium)

= 3% + 1.2 × 6%

= 3% + 7.2%

= 10.2%

After the change,

Required return= risk free rate + beta (market risk premium)

= 3% + 1.2 × 7%

= 3% + 8.4%

= 11.4%

Graph shown below

As the market risk premium increases, it leads to increase in required rate of return which eventually shifts the sml upwards. This can be seen from the graph.