The following graph plots the current security market line (SML) and indicates the return that investors require from holding stock from Happy Corp. (HC). Based on the graph, complete the table that follows. For graph see image 13a CAPM ElementsValueRisk-free rate (rRFRF) Market risk premium (RPMM) Happy Corp. stock’s beta Required rate of return on Happy Corp. stock An analyst believes that inflation is going to increase by 2.0% over the next year, while the market risk premium will be unchanged. The analyst uses the Capital Asset Pricing Model (CAPM). The following graph plots the current SML.Calculate Happy Corp.’s new required return. Then, on the graph, use the green points (rectangle symbols) to plot the new SML suggested by this analyst’s prediction.Happy Corp.’s new required rate of return is _____?. For grapgh see image 13b The SML helps determine the level of risk aversion among investors. The steeper the slope of the SML, the higher or lower the level of risk aversion?. Which kind of stock is most affected by changes in risk aversion? (In other words, which stocks see the biggest change in their required returns?)High-beta stocks Medium-beta stocks All stocks affected the same, regardless of beta Low-beta stocks ### Understanding Risk and Required Rate of ReturnThe graph presented illustrates the relationship between risk (measured by Beta) and the required rate of return (measured in percent) for an investment. #### Key Components of the Graph:1. **Axes:** - The **horizontal axis (X-axis)** represents **Risk (Beta)**, ranging from 0 to 2.0. - The **vertical axis (Y-axis)** represents the **Required Rate of Return (percent)**, ranging from 0.0% to 20.0%.2. **Data Point:** - The graph plots a specific data point denoted as “HC's Stock”. - The coordinates of this data point are (1.2, 10.4), indicating that for HC's Stock: - **Beta (Risk) = 1.2** - **Required Rate of Return = 10.4%**3. **Lines:** - A **blue line** depicts the general trend or expected relationship between risk and required rate of return. - **Orange dashed lines** are used to highlight and correlate HC’s Stock to both axes: - The horizontal orange dashed line extends from the Y-axis at 12.0% to the point representing HC’s Stock. - The vertical orange dashed line extends from the X-axis at Beta 1.2 to the point representing HC’s Stock.### Explanation of Beta and Required Rate of Return:- **Risk (Beta):** Beta measures the volatility or risk of a stock relative to the overall market. - A Beta of 1 implies that the stock's price will move with the market. - A Beta less than 1 indicates that the stock is less volatile than the market. - A Beta greater than 1 indicates that the stock is more volatile than the market.- **Required Rate of Return:** This is the minimum percentage return that an investor expects to achieve by investing in a particular stock, given its risk level.#### Interpretation:For HC's Stock, with a Beta of 1.2, investors would expect a required rate of return of approximately 10.4%. The plotted lines indicate the intersection of this risk level with the return expectation, highlighting where HC's Stock stands in relation to the overall market risk-return tradeoff.This graph helps in visualizing and understanding how different levels of risk can influence the expected returns on investments, aiding investors ### Understanding the Security Market Line (SML)#### Graph DescriptionThe graph above illustrates the Security Market Line (SML), a visualization fundamental to the Capital Asset Pricing Model (CAPM). The SML plots the relationship between the required rate of return (vertical axis) and the risk (horizontal axis), measured by Beta (β). #### Axes- **Horizontal Axis (X-Axis):** Represents the risk of an investment, quantified by Beta (β). The range extends from 0 to 2.0.- **Vertical Axis (Y-Axis):** Represents the required rate of return in percentage terms. The range extends from 0% to 20%.#### Line RepresentationThe blue upward-sloping line represents the Security Market Line (SML). Key properties:- The slope of the SML reflects the market risk premium, which is the additional return expected from holding a risky market portfolio instead of risk-free assets.- The SML intercepts the vertical axis at the risk-free rate of return where Beta (β) is equal to 0.#### HighlightTo the right of the graph, "New SML" is mentioned, indicating a potential shift or change in the expected SML, although it is not directly plotted on the graph.#### Interpretation- **Beta (β):** A measure of a stock's volatility in relation to the overall market. A Beta of 1 implies the stock has volatility equal to the market. Higher Beta (>1) indicates more risk (and potentially higher return), while lower Beta (<1) indicates less risk.- **Required Rate of Return:** The return an investor expects to achieve for a given level of risk. Higher Beta implies higher required return.#### Important Concepts- **Risk-Free Rate:** The return on an investment with zero risk, typically associated with government bonds.- **Market Risk Premium:** The difference between the expected return on the market portfolio and the risk-free rate. Understanding SML helps investors make informed decisions about the risk-return tradeoff for investments in the stock market.

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The following graph plots the current security market line (SML) and indicates the return that investors require from holding stock from Happy Corp. (HC). Based on the graph, complete the table that follows. For graph see image 13a CAPM Elements Value Risk-free rate (rRFRF) Market risk premium (RPMM) Happy Corp. stock’s beta Required rate of return on Happy Corp. stock An analyst believes that inflation is going to increase by 2.0% over the next year, while the market risk premium will be unchanged. The analyst uses the Capital Asset Pricing Model (CAPM). The following graph plots the current SML. Calculate Happy Corp.’s new required return. Then, on the graph, use the green points (rectangle symbols) to plot the new SML suggested by this analyst’s prediction. Happy Corp.’s new required rate of return is _____?. For grapgh see image 13b The SML helps determine the level of risk aversion among investors. The steeper the slope of the SML, the higher or lower the level of risk aversion?. Which kind of stock is most affected by changes in risk aversion? (In other words, which stocks see the biggest change in their required returns?) High-beta stocks Medium-beta stocks All stocks affected the same, regardless of beta

11th Edition

ISBN:9781260013924

Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Chapter1: Investments: Background And Issues

Section: Chapter Questions

Problem 1PS

CAPM Elements	Value
Risk-free rate (rRFRF)
Market risk premium (RPMM)
Happy Corp. stock’s beta
Required rate of return on Happy Corp. stock