Finance stocks question

Business & Finance
Tutor: None Selected Time limit: 1 Day

If investors’ aversion to risk increased, would the risk premium on a high-beta stock increase by more or less than that on a low-beta stock?  Explain for me please. 

Apr 17th, 2015

If investors’ aversion to risk increased then the risk premium on high-beta stock increase more than that on a low-beta stock. It is because the effect of the change in the risk aversion is stronger on more risky securities than in less riskier securities. Beside this, there is the positive relationship between risk aversion and the risk premium. If the risk aversion increases then the risk premium also goes up causing the slope of the security market line (SML) to become steeper. The steeper the Security market lines higher the required rate of return. Risk premium for stock x can be calculated as: Risk premium of market (RPM) multiply by beta of stock x (βx). 

For example,

Market risk premium (RPM) = 6%

Beta for stock X = 0.7

Beta for stock Y = 1.4

Now, calculation of risk premium for stock X and Y.

Risk premium for stock X = Market risk premium X beta

    = 6% X 0.7

    = 4.2%

Risk premium for stock Y = Market risk premium X beta

    = 6% X 1.4

    = 8.4%

Again, let’s suppose investors’ risk aversion increase that leads market risk premium to increase from 6% to 8% and beta for those stock remain the same.

Risk premium for stock X = Market risk premium X beta

    = 8% X 0.7

    = 5.6%

Risk premium for stock Y = Market risk premium X beta

    = 8% X 1.4

    = 11.2%

The above example clearly shows that risk premium for stock Y which has higher beta increase more than stock X which has lower beta. Therefore, risk premium on a high-beta stock increase more than low beta stock when investors’ aversion to risk increase.

http://dineshperspective.blogspot.com/2011/05/financial-management-problem-and.html


Hope this helps!


Apr 17th, 2015

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