Changes in Risk Aversion
by MaestriThe slope of the Security Market Line reflects the extent to which investors are averse to risk—the steeper the slope of the line, the greater the average investor’s risk aversion. Suppose investors were indifferent to risk; that is, they were not risk averse. If rRF were 6 percent, then risky assets would also provide an expected return of 6 percent, because if there were no risk aversion, there would be no risk premium, and
the SML would be plotted as a horizontal line. As risk aversion increases, so does the risk premium, and this causes the slope of the SML to become steeper.
Figure 3-14 illustrates an increase in risk aversion. The market risk premium rises from 5 to 7.5 percent, causing rM to rise from rM1 11% to rM2 13.5%. The returns on other risky assets also rise, and the effect of this shift in risk aversion is more pronounced on riskier securities. For example, the required return on a stock with bi 0.5 increases by only 1.25 percentage points, from 8.5 to 9.75 percent, whereas that on a stock with bi 1.5 increases by 3.75 percentage points, from 13.5 to 17.25 percent.
Changes in a Stock’s Beta Coefficient
As we shall see later in the book, a firm can influence its market risk, hence its beta, through changes in the composition of its assets and also through its use of debt. A company’s beta can also change as a result of external factors such as increased competition in its industry, the expiration of basic patents, and the like. When such changes occur, the required rate of return also changes, and, as we shall see in Chapter 5, this
will affect the firm’s stock price. For example, consider MicroDrive Inc., with a beta of 1.40. Now suppose some action occurred that caused MicroDrive’s beta to increase from 1.40 to 2.00.
As we shall see in Chapter 5, this change would have a dramatic effect on MicroDrive’s stock.
Taken From : Five-Minute MBA – Corporate Finance
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