136 CHAPTER 3 Risk and Return
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 rMto rise from rM111% to rM213.5%. 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 bi1.5 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 compe-
tition 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. If the conditions depicted in Figure 3-12 held, MicroDrive’s re-
quired rate of return would increase from 13 to 16 percent:
r 1 rRFRPMb 1
6% (5%)1.40
13%
FIGURE 3-14 Shift in the SML Caused by Increased Risk Aversion
0 0.5 1.0 1.5 2.0 Risk, b i
Required Rate
of Return (%)
New Market Risk
Premium, rM2 – rRF = 7.5%
Original Market Risk
Premium, rM1 – rRF = 5%
8.5
9.75
17.25
SML 2 = 6% + 7.5%(bi)
SML 1 = 6% + 5%(bi)
rM1 = 11
rRF = 6
rM2 = 13.5
134 Risk and Return
