Shifts in the security market line Assume that the risk-free rate, RF, is currently 8%; the market return, rm, is 12%; and asset A has a beta, bA, of 1.10. a. Draw the security market line (SML) on a set of “nondiversifiable risk (x-axis)–required return (y-axis)” axes. b. Use the CAPM to calculate the required return, rA, on asset A, and depict asset A’s beta and required return on the SML drawn in part a. c. Assume that as a result of recent economic events, inflationary expectations have declined by 2%, lowering RF and rm to 6% and 10%, respectively. Draw the new SML on the axes in part a, and calculate and show the new required return for asset A.
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
Shifts in the security market line Assume that the risk-free rate, RF, is currently 8%; the market return, rm, is 12%; and asset A has a beta, bA, of 1.10.
a. Draw the security market line (SML) on a set of “nondiversifiable risk (x-axis)–required return (y-axis)” axes.
b. Use the CAPM to calculate the required return, rA, on asset A, and depict asset A’s beta and required return on the SML drawn in part a.
c. Assume that as a result of recent economic events, inflationary expectations have declined by 2%, lowering RF and rm to 6% and 10%, respectively. Draw the new SML on the axes in part a, and calculate and show the new required
d. Assume that as a result of recent events, investors have become more risk averse, causing the market return to rise by 1%, to 13%. Ignoring the shift in part c,draw the new SML on the same set of axes that you used before, and calculate and show the new required return for asset A.
e. From the previous changes, what conclusions can be drawn about the impact of (1) decreased inflationary expectations and (2) increased risk aversion on the required returns of risky assets?
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