Question

Suppose r_RF = 4%, r_M = 12%, and b_i = 1.9.

1. What is r_i, the required rate of return on Stock i? Round your answer to two decimal places.

Now suppose r_RF increases to 5%. The slope of the SML remains constant. How would this affect r_M and r_i?

Now assume that r_RF remains at 4%, but r_M increases to 13%. The slope of the SML does not remain constant. How would these changes affect r_i? Round your answer to two decimal places.

Now assume that r_RF remains at 4%, but r_M falls to 11%. The slope of the SML does not remain constant. How would these changes affect r_i? Round your answer to two decimal places.

Answer 1

As per CAPM,

Required return = Risk free Rate + (Market return - Risk Free rate) x Beta

Case 1)

Required return = 4% + (12 - 4)% x 1.9 = 4% + 15.2% = 19.20%

Case 2)

Required return = 5% + (12 - 4)% x 1.9 = 5% + 15.2% = 20.20%

Thus,

Required return increases by 1.00%

Case 3)

Required return = 4% + (13 - 4)% x 1.9 = 4% + 17.1% = 21.10%

Thus,

Required return increases by 1.90%

Case 4)

Required return = 4% + (11 - 4)% x 1.9 = 4% + 13.3% = 17.30%

Thus,

Required return falls by 1.90%