Please, explain in a very accurate and detailed way, provide logical and consist
ID: 2756642 • Letter: P
Question
Please, explain in a very accurate and detailed way, provide logical and consistent answer. It is very important in this task. Provide VERY DETAILED explanation.
If the price of money (e.g., interest rates and equity capital costs) increases due to an increase of anticipated inflation, the risk-free rate will also increase. If there is no change in investment aversion, then the market risk premium (r_M - r_RF) will remain constant. Also if there is change in stocks' betas, then the required rate of return on each stock as measured by will increase by the same amount as the increase in expected inflation.
Explanation / Answer
If the price of money (e.g., interest rates and equity capital costs) increases due to an increase of anticipated inflation, the risk-free rate will also increase.
Ans:-
Yes, due to increase in Interest rate which is caused by increase in inflation, generally risk free rate will increase as risk free rate consist of default risk, currency risk, and inflation risk. Mainly it is consist of inflation risk. One interpretation of the theoretical risk-free rate is aligned to Irving Fisher's concept of inflationary expectations, described in his treatise The Theory of Interest (1930), which is based on the theoretical costs and benefits of holding currency. In Fisher’s model, these are described by two potentially offsetting movements:
1. Expected increases in the money supply should result in investors preferring current consumption to future income.
2. Expected increases in productivity should result in investors preferring future income to current consumption.
The correct interpretation is that the risk-free rate could be either positive or negative and in practice the sign of the expected risk-free rate is an institutional convention – this is analogous to the argument that Tobin makes on page 17 of his book Money, Credit and Capital. In a system with endogenous money creation and where production decisions and outcomes are decentralized and potentially intractable to forecasting, this analysis provides support to the concept that the risk-free rate may not be directly observable.
However, it is commonly observed that for people applying this interpretation, the value of supplying currency is normally perceived as being positive. It is not clear what is the true basis for this perception, but it may be related to the practical necessity of some form of (credit?) currency to support the specialization of labour, the perceived benefits of which were detailed by Adam Smith in The Wealth of Nations. However, Smith did not provide an 'upper limit' to the desirable level of the specialization of labour and did not fully address issues of how this should be organised at the national or international level.
An alternative (less well developed) interpretation is that the risk-free rate represents the time preference of a representative worker for a representative basket of consumption. Again, there are reasons to believe that in this situation the risk-free rate may not be directly observable.
A third (also less well developed) interpretation is that instead of maintaining pace with purchasing power, a representative investor may require a risk free investment to keep pace with wages.
Given the theoretical 'fog' around this issue, in practice most industry practitioners rely on some form of proxy for the risk-free rate, or use other forms of benchmark rate which are presupposed to incorporate the risk-free rate plus some risk of default.
If there is no change in investment aversion, then the market risk premium (r_M - r_RF) will remain constant.
Yes, taking a example
The base case SML is based on rRF = 8% and rM = 15%. If inflation expectations increase by 3 percentage points, with no change in risk aversion, then the entire SML is shifted upward(Parallel to the base case SML) by 3 percentage points. Now, rRF = 11%, rM =18%, and all securities’ required returns rise by 3 percentage points. Note that the market risk premium, rm rRF, remains at 7 percentage points.
Also if there is change in stocks' betas, then the required rate of return on each stock as measured by will increase by the same amount as the increase in expected inflation.
Yes,If expected inflation increases 3 percent, the stock's expected return will increase by 3 percent. According to the Security Market Line (SML) equation, an increase in beta will increase
a company’s expected return by an amount equal to the market risk premium times the change in beta. For example, assume that the risk-free rate is 6 percent, and the market risk premium is 5 percent. If the company’s beta doubles from 0.8 to 1.6 its expected return increases from 10 percent to 14 percent. Therefore, in general, a company’sexpected return will not double when its beta doubles.