Security Market Line The security market line (SML) is an equation that shows th
ID: 2763428 • Letter: S
Question
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--------- to compensate the investor for risk. If a stock's expected return plots below the SML, the stock's return is ------ to compensate the investor for risk.
The SML line can change due to expected inflation and risk aversion. If inflation changes, then the SML plotted on a graph will shift up or down parallel to the old SML. If risk aversion changes, then the SML plotted on a graph will rotate up or down becoming more or less steep if investors become more or less risk averse. A firm can influence market risk (hence its beta coefficient) through changes in the composition of its assets and through changes in the amount of debt it uses.
Quantitative Problem: You are given the following information for Wine and Cork Enterprises (WCE):
rRF = 4%; rM = 8%; RPM = 4%, and beta = 1.4
What is WCE's required rate of return? Round your answer to 2 decimal places. Do not round intermediate calculations
--------%
If inflation increases by 1% 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 1% 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
Explanation / Answer
SML Equation Required Return = rRf + rPM * Beta where, rRf is risk free rate of return rPM =Risk Premium If a stock's expected return plots on or above the SML, then the stock's return is higher than expected to compensate the investor for risk. If a stock's expected return plots below the SML, the stock's return is lower than expected to compensate the investor for risk. rRF = 4%; rM = 8%; RPM = 4%, and beta = 1.4 a. Required rate of return = rRF + rPM* beta = 4% + 4%*1.4 = 9.6% b. % If inflation increases by 1% rRF increase by same 1%, but risk attitude remains constant Required Rate of Return = 5% + 4% *1.4 = 10.6% SML Shifts upwards c. % If inflation stays constant but risk averseness increases by 2% rRF remains constant, but rPM Increases by 2% Required Rate of Return = 4% + 6% *1.4 = 12.4% SML becomes steeper d. % If inflation and risk averseness both increases by 1% and 2% respectively rRF by 1% and rPM Increases by 2% Required Rate of Return = 5% + 6% *1.4 = 13.4%