The risk premium on a high beta stock would increase more. [ mathrm{RP}_{mathrm{j}}=text { Risk Premium for
Question:
The risk premium on a high beta stock would increase more.
\[ \mathrm{RP}_{\mathrm{j}}=\text { Risk Premium for Stock } \mathrm{j}=\left(\mathrm{r}_{\mathrm{M}}-\mathrm{r}_{\mathrm{RF}}\right) \mathrm{b}_{\mathrm{j}} \]
If risk aversion increases, the slope of the SML will increase, and so will the market risk premium ( \(r_{M}-r_{R F}\) ). The product \(\left(r_{M}-r_{R F}\right) b_{j}\) is the risk premium of the jth stock. If \(b_{j}\) is low (say, 0.5 ), then the product will be small; \(\mathrm{RP}_{\mathrm{j}}\) will increase by only half the increase in \(\mathrm{RP}_{\mathrm{M}}\). However, if \(\mathrm{b}_{\mathrm{j}}\) is large (say, 2.0), then its risk premium will rise by twice the increase in \(\mathrm{RP}_{\mathrm{M}}\).
Step by Step Answer:
Financial Management Theory And Practice
ISBN: 9780324259681
11th Edition
Authors: Eugene F Brigham, Michael C Ehrhardt