Question: Assume the risk-free rate is 3.0% and the required return on the market portfolio is 12.0%. Suppose the expected rate of inflation is constant at 3.0%, but the market risk premium increases to 11.0%.
(i) Write the new equation for the Security Market Line.
(ii) Show how the graph of the SML would be affected by this change?
(iii) Under these new conditions, what is the required return on a stock with a beta of 2.0?
(iv) Is this an example of investors becoming more risk averse, or less risk averse, or neither? Explain.