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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

In Chapter 7, we saw that if the market interest rate, rd, for a given bond increased, the price of the bond would decline. Applying this same logic to stocks, explain (a) how a decrease in risk aversion would affect stocks’ prices and earned rates of return, (b) how this would affect risk premiums as measured by the historical difference between returns on stocks and returns on bonds, and (c) what the implications of this would be for the use of historical risk premiums when applying the SML equation.

a.

Summary Introduction

To explain: The influence of risk aversion on the stock prices and earned rates of return.

Market Interest Rate:

The market interest rate refers to that rate of interest, which is prevailing in the market at the present. The market interest rate is the rate which is offered on the deposits of cash. It depends upon the amount and the duration of the deposits.

The Risk Aversion:

The aversion of risk means taking lower risks on the investments. Risk aversion means the investor prefers the known risks in lower return investments but will not prefer those investments which have higher returns with unknown risks.

Explanation
  • The term risk aversion in case of an investment means that the investor is ready to take the known risks even if the investment gives a lower return...

b.

Summary Introduction

To explain: The affect on risk premiums as measured by the difference between returns on stocks and return on bonds.

Risk premium:

The risk premium refers to that amount which is the difference between the amount that is earned on a risk-free asset and the return, which is earned on the risky asset. This risk premium is the excess return on investment other than the risk-free rate of return on an investment that is expected to yield.

c.

Summary Introduction

To explain: The implications for the use of historical risk premium when the SML equation is applied.

Security Market Line:

The security market line is a graph of the Capital asset pricing model. The slope of the security market line calculates the market risk premium. In this line, the x-axis represents the risk, which is beta and the y-axis represents the expected return.

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