Changes in Risk Aversion

The slope of the Security Market Line reflects the extent to which investors are averse to risk—the steeper the slope of the line, the greater the average investor's risk aversion. Suppose investors were indifferent to risk; that is, they were not risk averse. If rRF were 6 percent, then risky assets would also provide an expected return of 6

15Long-term Treasury bonds also contain a maturity risk premium, MRP. Here we include the MRP in r* to simplify the discussion.

16Recall that the inflation premium for any asset is equal to the average expected rate of inflation over the asset's life. Thus, in this analysis we must assume either that all securities plotted on the SML graph have the same life or else that the expected rate of future inflation is constant.

It should also be noted that r^p 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 than between T-bill yields and stocks. See Stocks, Bonds, Bills, and Inflation: 2001 Valuation Edition Yearbook (Chicago: Ibbotson Associates, 2001) for a discussion.

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 rM to rise from rM1 = 11% to rM2 = 13.5%. 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 bi = 1.5 increases by 3.75 percentage points, from 13.5 to 17.25 percent.

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