11. Changes to the security market line

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:

CAPM Elements	Value
Risk-free rate (rRFrRF)
Market risk premium (RPMRPM)
Happy Corp. stocks 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 analysts prediction.

Happy Corp.s new required rate of return is .

Tool tip: Mouse over the points on the graph to see their coordinates.

The SML helps determine the level of risk aversion among investors. The steeper the slope of the SML, the 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

All stocks affected the same, regardless of beta

Medium-beta stocks

Low-beta stocks

20.01 Return on HC's Stock REQUIRED RATE OF RETURN (Percent) 1.0 RISK (Beta) New SML REQUIRED RATE OF RETURN (Percent) 0.4 1.6 2.0 0.8 1.2 RISK (Beta)