Question

Suppose r_RF = 3%, r_M = 13%, and b_i = 1.4.

2. Now suppose r_RF decreases to 2%. The slope of the SML remains constant. How would this affect r_M and r_i?

-Select-IIIIIIIVVItem 3

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

2. 1. Now suppose r_RF increases to 4%. The slope of the SML remains constant. How would this affect r_M and r_i?

   1. Both r_M and r_i will increase by 1%.
   2. r_M will remain the same and r_i will increase by 1%.
   3. r_M will increase by 1% and r_i will remain the same.
   4. Both r_M and r_i will decrease by 1%.
   5. Both r_M and r_i will remain the same.
   
   
   -Select-IIIIIIIVVItem 2
   1. Both r_M and r_i will remain the same.
   2. Both r_M and r_i will decrease by 1%.
   3. r_M will decrease by 1% and r_i will remain the same.
   4. r_M will remain the same and r_i will decrease by 1%.
   5. Both r_M and r_i will increase by 1%.

3. 1. Now assume that r_RF remains at 3%, but r_M increases to 14%. The slope of the SML does not remain constant. How would these changes affect r_i? Round your answer to two decimal places.

   The new r_i will be  %.

   2. Now assume that r_RF remains at 3%, but r_M falls to 12%. The slope of the SML does not remain constant. How would these changes affect r_i? Round your answer to two decimal places.

   The new r_i will be  %.

Answer 1

Using SML and CAPM

Expected return = Risk free rate + Beta * ( Market premium)

= 3%+ 1.4 * ( 13% -3%)

= 17%

If the risk free return decreases to 2%

Then expected return = 2% + 1.4 * (13% -3%) = 16%

b) The correct option is r_M will remain the same and r_i will increase by 1%.

c) 1. Expected return = Risk free rate + Beta * ( Market premium)

= 3% + 1.4 * ( 14% -3%) = 17.4%

2. Expected return = Risk free rate + Beta * ( Market premium)

= 3% + 1.4 * ( 12% -3%) = 15.6%