Intermediate Financial Management (with Thomson One)

4. The values we worked out for stocks with b i 0.5, b i 1.0, and b i 2.0
agree with the values shown on the graph for r L , r A , and r H .
Both the Security Market Line and a company’s position on it change over
time due to changes in interest rates, investors’ aversion to risk, and individual
companies’ betas. Such changes are discussed in the following sections.
The Impact of Inflation
Interest is the same as “rent” on borrowed money, or the price of money. Thus,
r RF is the price of money to a riskless borrower. The risk-free rate as measured by
the rate on U.S. Treasury securities is called the nominal, or quoted, rate, and it
consists of two elements: (1) a real inflation-free rate of return, r*, and (2) an
inflation premium, IP, equal to the anticipated rate of inflation. 10 Thus, r RF r*
IP. The real rate on long-term Treasury bonds has historically ranged from 2 to
4 percent, with a mean of about 3 percent. Therefore, if no inflation were
expected, long-term Treasury bonds would yield about 3 percent. However, as the
expected rate of inflation increases, a premium must be added to the real risk-free
rate of return to compensate investors for the loss of purchasing power that
results from inflation. Therefore, the 6 percent r RF shown in Figure 2-10 might be
thought of as consisting of a 3 percent real risk-free rate of return plus a 3 percent
inflation premium: r RF r* IP 3% 3% 6%.
If the expected inflation rate rose by 2 percent, to 3% 2% 5%, this
would cause r RF to rise to 8 percent. Such a change is shown in Figure 2-11.
Figure 2-11
Required Rate
of Return (%)
r M2 = 13
r M1 = 11
r RF2 = 8
r RF1 = 6
r* = 3
Shift in the SML Caused by an Increase in Inflation
Original IP = 3%
Increase in Anticipated Inflation, ΔIP = 2%
Real Risk-Free Rate of Return, r*
SML 2 = 8% + 5%(b i )
SML 1 = 6% + 5%(b i )
0 0.5 1.0 1.5 2.0 Risk, b i
10 Long-term Treasury bonds also contain a maturity risk premium, MRP. Here we include the MRP in r* to simplify the
discussion.
Chapter 2 Risk and Return: Part I • 61