Principles of Managerial Finance

CHAPTER 5 Risk and Return 243

Required Return,

k

(%)

17

18

19

20

21

22

16

15

km 1 = 14

kZ = 13

12

km = 11

10

9

8

RF = 7

6 5 4 3 2 1

0 .5 1.0 1.5 2.0

SML

bRF bm bZ

Nondiversifiable Risk, b

SML 1

kZ 1 = 17.5

New Market Risk Premium

km 1

• RF = 7%

Initial Market

Risk Premium

km – RF = 4%

FIGURE 5.12

Risk Aversion Shifts SML
Impact of increased risk
aversion on the SML

ket crash, assassination of a key political leader, and the outbreak of war. In gen-

eral, widely accepted expectations of hard times ahead tend to cause investors to

become more risk-averse, requiring higher returns as compensation for accepting

a given level of risk. The impact of increased risk aversion on the SML can best be

demonstrated by an example.

EXAMPLE In the preceding examples, the SML in Figure 5.10 reflected a risk-free rate (RF)of

7%, a market return (km) of 11%, a market risk premium (kmRF) of 4%, and a

required return on asset Z (kZ) of 13% with a beta (bZ) of 1.5. Assume that recent

economic events have made investors more risk-averse, causing a new higher mar-

ket return (km 1 ) of 14%. Graphically, this change would cause the SML to shift

upward as shown in Figure 5.12, causing a new market risk premium (km 1 RF)

of 7%. As a result, the required return on all risky assets will increase. For asset Z,

with a beta of 1.5, the new required return (kZ 1 ) can be calculated by using

CAPM (Equation 5.8):

kZ 1 7%[1.5(14%7%)]7%10.5% 1



7



.



5



%

This value can be seen on the new security market line (SML 1 ) in Figure 5.12.

Note that although asset Z’s risk, as measured by beta, did not change, its

required return has increased because of the increased risk aversion reflected in