Fundamentals of Financial Management (Concise 6th Edition)

254 Part 3 Financial Assets

saw that the risk-free rate as measured by the rate on U.S. Treasury securities

is called the nominal, or quoted, rate; and it consists of two elements: (1) a real

in" ation-free rate of return, r* and (2) an in" ation premium, IP, equal to the anticipated

rate of in! ation.^23 Thus, rRF $ r* + IP. The real rate on long-term Treasury bonds has

historically ranged from 2% to 4%, with a mean of about 3%. Therefore, if no

in! ation were expected, long-term Treasury bonds would yield about 3%. How-

ever, as the expected rate of in! ation increases, a premium must be added to the

real risk-free rate of return to compensate investors for the loss of purchasing

power that results from in! ation. Therefore, the 6% rRF shown in Figure 8-8 might

be thought of as consisting of a 3% real risk-free rate of return plus a 3% in! ation

premium: rRF $ r* " IP $ 3% " 3% $ 6%.

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Key Inputs Beta

0.0 0.5 1.0 1.5 2.0 2.5

Required Rate

of Return (%)

6.0%

11.0

5.0

rRF

rM

RPM = rM – rRF

Riskless asset:

Stock L:

Stock A:

Stock H:

0.0

0.5

1.0

2.0

6.00%

8.50

11.00

16.00

rRF = 6.0%

rL = 8.5%

rA = rM = 11.0%

rH = 16.0%

H’s Risk

Premium

L’s Risk

Premium

Risk-Free

Return, rRF

Market Risk

Premium, RPM.

Also Stock A’s

Risk Premium

Beta Coe&cient

ri = rRF + RPM(bi)

SML = rRF + RPM x bi

ri

The Security Market Line (SML)

F I G U R E 8! 8

(^23) Long-term Treasury bonds also contain a maturity risk premium, MRP. We include the MRP in r* to simplify the
discussion.