(a) how a decrease in risk aversion would affect stocks ...
If the market interest rate, Rd, for a given bond increased, then the price of the bond would decline. Applying this same logic to stocks, explain
a) how a decrease in risk aversion would affect stocks' prices and earned rates of return, (b) how this would affect risk premiums as measured by the historical difference between returns on stocks and returns on bonds, and (c) the implications of this for the use of historical risk premiums when applying the SML equation. Support your positions
A decrease in risk aversion is an indication of the investors' optimism regarding the economy and corporate profits, this optimism would be reflected in the decrease of expected returns, and since there is an inverse relationship between interest rates and prices, therefore a decrease in the required rate of return would result in an increase in the prices of stock. When the return on stocks decrease, the spread (risk premium) between stocks and bonds would, consequently decrease.
The Security Market Line (SML) reflects the relationship between Required Returns (plotted on the y axis), and Beta (plotted on the x axis). The SML equation is:
Required Return = Risk Free Rate + [Beta(Market Risk Premium)], where the risk free rate of return is the return on government securities which is believed to have the lowest possible risk, market risk premium is the difference between the return on the market portfolio less the risk free rate of return, and finally Beta is a measure of systematic risk and represents the covariance between return on market portfolio and the return on the security / Variance of the return on the market portfolio.
In our analysis, Beta does not change because it is an indication of the systematic risk (Risk that cannot be diversified), and the risk free rate of return does not change because risk is not involved in our analysis. It is the slope of the SML (Market Risk Premium) that reflects the level of risk aversion, the higher the level of risk aversion, the steeper is the slope of the SML, and the opposite is true.
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