Asked by Joshua Rieser on Jun 09, 2024
Verified
Which of the following statements is correct?
A) A graph of the SML as applied to individual stocks would show required rates of return on the vertical axis and standard deviations of returns on the horizontal axis.
B) The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt.
C) If investors become more risk averse, then (1) the slope of the SML would increase and (2) the required rate of return on low-beta stocks would increase by more than the required return on high-beta stocks.
D) An increase in expected inflation, combined with a constant real risk-free rate and a constant market risk premium, would lead to identical increases in the required return on a riskless asset and on an average stock, other things held constant.
SML
Security Market Line, a graphical representation of the Capital Asset Pricing Model (CAPM) showing the relationship between the expected return of a security and its risk.
CAPM
Short for Capital Asset Pricing Model, a financial model that describes the relationship between systematic risk and expected return for assets.
Required Rates of Return
The minimum annual percentage earnings needed from an investment to compensate for its risk, serving as a benchmark for evaluating potential investments.
- Master the fundamentals of the Security Market Line (SML) and its relevance to required returns in relation to beta.
- Analyze the effects of changes in investor risk aversion on the market risk premium and the slope of the SML.
Verified Answer
EN
Emily NavarroJun 14, 2024
Final Answer :
D
Explanation :
According to the Fisher effect, an increase in expected inflation would lead to an increase in the nominal risk-free rate, which would lead to an increase in the required return on both a riskless asset and on an average stock. Therefore, choice D is correct. Choice A is incorrect because a graph of the SML as applied to individual stocks would show required rates of return on the horizontal axis and betas on the vertical axis. Choice B is incorrect because the CAPM has faced some empirical challenges and its assumptions have been criticized. Choice C is incorrect because an increase in risk aversion would increase the slope of the SML and increase the required return on all stocks, but the increase would be greater for high-beta stocks.
Learning Objectives
- Master the fundamentals of the Security Market Line (SML) and its relevance to required returns in relation to beta.
- Analyze the effects of changes in investor risk aversion on the market risk premium and the slope of the SML.