Question

An analyst believes that inflation is going to increase by 2.0% over the next year, while the market risk premium will be unchanged. The analyst uses the Capital Asset Pricing Model (CAPM). The following graph plots the current SML Calculate Happy Corp.'s new required return. Then, on the graph, use the green points (rectangle symbols) to plot the new SML suggested by this analyst's prediction. Happy Corp's new required rate of return is Took tip: House over the points in the graph to see their coordinates.

Answer 1

Investment analysis includes understanding the expected rate of return, the risk involved, and liquidity. The Capital Asset Pricing Model (CAPM) suggests that if inflation increases, required returns on investments will also increase. High-risk investments often have the potential for high returns, justifying the greater risk.

Step-by-step explanation:

Understanding Investment Returns, Risks, and CAPM

The analysis of investments like stocks, bonds, and savings accounts must consider factors such as expected rate of return, risk, and liquidity. The expected rate of return is the average expected yield of an investment over time, usually expressed as a percentage. Risk encompasses the uncertainty of the return on investment and involves various types, such as default risk and interest rate risk. High-risk investments commonly offer the potential for high returns to compensate for this unpredictability.

When using the Capital Asset Pricing Model (CAPM) to calculate the required return on an investment such as that of Happy Corp., if an analyst anticipates an increase in inflation by 2.0%, this would shift the Security Market Line (SML) upward, suggesting a higher required return for all investments, not just Happy Corp. This prediction is based on the fact that as inflation rises, investors demand greater returns to compensate for the loss of purchasing power of their money.

Investments have varied performances, with stocks typically yielding higher returns compared to bonds over time, while savings accounts offer stability with very little change in value. The relationship between risk and return implies that while high-risk investments can lead to losses, they can also provide substantial gains compared to lower-risk investments.

Answer 2

Happy Corp.'s new required return using the Capital Asset Pricing Model (CAPM), you can modify the formula to account for the change in inflation and calculate the new required return. Then, you can use the Security Market Line (SML) to graphically represent the relationship between expected return and beta, incorporating the prediction of the analyst.

Happy Corp.'s new required return using the Capital Asset Pricing Model (CAPM), you can follow these steps:

1. CAPM Formula: The CAPM formula is given by: Required Return (Expected) = Risk-Free Rate + β × Market Risk Premium
2. Given Information: Analyst predicts inflation to increase by 2.0%. Market risk premium is unchanged. The formula can be modified to account for the change in inflation: Required Return (Expected) = Risk-Free Rate + β × (Market Risk Premium + Inflation Rate)
3. Calculate the New Required Return: Let's assume the current risk-free rate is rf, the current market risk premium is MRP, and Happy Corp.'s beta is β. New Required Return = rf + β × (MRP + Inflation Rate)
4. Graphical Representation: Use the Security Market Line (SML) to graphically represent the relationship between expected return and beta. The SML equation is: Expected Return = Risk-Free Rate + β × Market Risk Premium. Given that the market risk premium is unchanged, the new SML equation incorporating the analyst's prediction is: Expected Return (New) = Risk-Free Rate + β × (MRP + Inflation Rate). Plot points on the graph using Happy Corp.'s beta and the corresponding new required return calculated.