Chapter 8 Risk and Rates of Return 255If the expected in! ation rate rose by 2%, to 3% " 2% $ 5%, rRF would rise to
8%. Such a change is shown in Figure 8-9. Notice that the increase in rRF leads to an
equal increase in the rates of return on all risky assets because the same in! ation
premium is built into required rates of return on both riskless and risky assets.^24
Therefore, the rate of return on our illustrative average stock, rA, increases from
11% to 13%. Other risky securities’ returns also rise by two percentage points.
8-4b Changes in Risk Aversion
The slope of the SML re! ects the extent to which investors are averse to risk—the
steeper the slope of the line, the more the average investor requires as compensa-
tion for bearing risk. Suppose investors were indifferent to risk; that is, they were
not at all risk-averse. If rRF was 6%, risky assets would also have a required return
of 6% because if there were no risk aversion, there would be no risk premium. In
that case, the SML would plot as a horizontal line. However, because investors are
risk-averse, there is a risk premium; and the greater the risk aversion, the steeper
the slope of the SML.
(^24) Recall that the in" ation premium for any asset is the average expected rate of in" ation over the asset’s life.
Thus, in this analysis, we must assume that all securities plotted on the SML graph have the same life or that the
expected rate of future in" ation is constant.
It should also be noted that rRF in a CAPM analysis can be proxied by either a long-term rate (the T-bond
rate) or a short-term rate (the T-bill rate). Traditionally, the T-bill rate was used; but in recent years, there has been
a movement toward use of the T-bond rate because there is a closer relationship between T-bond yields and
stocks’ returns than between T-bill yields and stocks’ returns. See Stocks, Bonds, Bills, and In# ation: (Valuation
Edition) 2008 Yearbook (Chicago: Morningstar, Inc., 2008) for a discussion.
0 0.5 1.0 1.5 2.0 Risk, b i
rA2 = rM2 = 13
rA1 = rM1 = 11
rRF2 = 8
Required Rate
of Return (%)
rRF1 = 6
r = 3
Original IP = 3%
Increase in Anticipated In%ation, $IP = 2%
Real Risk-Free Rate of Return, r
SML 2 = 8% + 5%(bi)
SML 1 = 6% + 5%(bi)
Shift in the SML Caused by an Increase in Expected Inf lation
F I G U R E 8! 9