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Assume risk-free rate is 4% and the market risk premium is 5%. If the overall market’s...

Assume risk-free rate is 4% and the market risk premium is 5%. If the overall market’s risk aversion increased so that the market risk premium increased to 8%, 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 1.6, what will be its required return before and after the change?

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Answer #1

We are given the below information:

Asset Return Beta Old New
Risk Free (Rf) 0 4.00% 4.00%
Market Portfolio (Rm) 1 9.00% 12.00%

Beta of Risk free rate is 0 because there is no risk to it while that of the market is 1 because its risk is compared to itself so the beta is 1

Market portfolio restun is calculated by adding the market risk premium to the risk free return:

  • Old: 4+5 = 9%
  • New:4+8 = 12%

Below graph shows the change in SML:

SML is the line joining the Risk free rate and the market return. As the market return increases, the SML becomes steeper

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