Part B 1. The nominal risk free rate of interest is a function of a. The real ri

ID: 2812464 • Letter: P

Question

Part B 1. The nominal risk free rate of interest is a function of a. The real risk free rate and the investment's variance. b. The prime rate and the rate of inflation c. The T-bill rate plus the inflation rate d. The tax free rate plus the rate of inflation. e. The real risk free rate and the rate of inflation. 2. Which of the following is not a component of the risk premium? a. Business risk b. Financial risk c. Liquidity risk d. Exchange rate risk e. Unsystematic market risk 3. The uncertainty of investment returns associated with how a firm finances its investments is known as a. Business risk b. Liquidity risk c. Exchange rate risk. d. Financial risk. e. Market risk. 4. What will happen to the security market line (SML) if the following events occur, other things constant: (1) inflation expectations increase, and (2) investors become more risk averse? Shift up and keep the same slope Shift up and have less slope Shift up and have a steeper slope Shift down and keep the same slope Shift down and have less slope

Explanation / Answer

Ans 1 (e) The nominal risk free rate of interest is the function of the real risk free rate and the rate of inflation.

Formula: Rf = (1+nominal risk free rate)/(1+inflation) -1

Ans 2 (e) Unsystematic market risk is not the component of the risk premium.

Risk Premium=Excess return over risk free rate

The five main risks which are the component of the risk premium are

Ans 3 (d ) Financial risk involves financial transactions related to investments or related to company’s capital structure. So The Uncertainty of investment returns associated with how a firm finances its investments is known as financial risk.

The rate of return which we expect from different investments can vary rather widely.

The risk of an investment depends upon the variability of rate of return. Risk and return of an investment are related, i.e higher the risk, the higher is the return.

Risks are of two types 1) Systematic risk 2) Unsystematic risk

Systematic Risk

Unsystematic risk

Interest rate risk

Business risk

Market risk

Financial risk

Purchasing power risk

Ans 4 ( C) Security Market line shows the relationship between risk as measured by Beta and required rate of return for individual securities.

SML: ri = rRF + (rM – rRF) bi.

The greater the average investor’s aversion to risk, then the steeper the slope of the line. The increase in inflation would cause the SML to shift up, and investors becoming more risk averse would cause the slope to increase.