Question

Risk and Rates of Return: Security Market Line

The security market line (SML) is an equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities. The SML equation is given below:

If a stock's expected return plots on or above the SML, then the stock's return is  -Select-insufficient, sufficient to compensate the investor for risk. If a stock's expected return plots below the SML, the stock's return is -Select-insufficient, sufficient to compensate the investor for risk.

Quantitative Problem: You are given the following information for Wine and Cork Enterprises (WCE):

rRF = 3%; rM = 7%; RPM = 4%, and beta = 1.3

What is WCE's required rate of return? Round your answer to 2 decimal places. Do not round intermediate calculations.
%

If inflation increases by 3% but there is no change in investors' risk aversion, what is WCE's required rate of return now? Round your answer to two decimal places. Do not round intermediate calculations.
%

Assume now that there is no change in inflation, but risk aversion increases by 2%. What is WCE's required rate of return now? Round your answer to two decimal places. Do not round intermediate calculations.
%

If inflation increases by 3% and risk aversion increases by 2%, what is WCE's required rate of return now? Round your answer to two decimal places. Do not round intermediate calculations.
%

Answer 1

If a stock's expected return plots on or above the SML, then the stock's return is sufficient to compensate the investor for risk. If a stock's expected return plots below the SML, the stock's return is insufficient to compensate the investor for risk.

Using CAPM :
Return = risk free + (Beta *Market risk premium)
=3%+(1.3*4)%=8.20%

If inflation increases by 3%, risk free shall be = 6%
Now return 6%+(1.3*4)%=11.20%

If risk aversion increases:
3%+(1.3*6)%=10.80%

If inflation increases by 3% and risk aversion increases by 2%:
=6%+(1.3*6)%=13.80%