I am having some trouble analyzing the effect of using a short-term government bill vs. a long-term government bond and the shape of the yield curve on the required rate of return derived from CAPM.
Using a long-term bond when the yield curve is upward-sloping will result in a lower risk premium + high risk free rate. But what is the ultimate effect on the required rate of return? A long-term bond will have offsetting effects on the components of the capm equation (increase Rf and decrease the Risk Premium) and hence, the ultimate effect on the required rate of return is ambiguous.
The topic I am referring to is topic 3.1.2 on Page 56 of the Equity Volume.
A higher risk-free rate and lower market risk premium will give you a less-steep Capital Market Line; thus, you’ll have higher expected returns for securities having β < 1 and lower expected returns for securities having β > 1.
A lower risk-free rate and higher market risk premium will give you a steeper Capital Market Line; thus, you’ll have lower expected returns for securities having β < 1 and higher expected returns for securities having β > 1.
For securities having β = 1, the expected return is the same either way.
Can you please give an actual example, i’m not seeing the relation even after writing out the formula. Since beta is the slope, wouldnt it always equate to a higher expected return for beta > 1 versus beta <1 regardless of how the RFR is changing.
Suppose that rf = _ 3% _, and E(Rm) = 8%; calculate the expected return for a stock with β = 0.9, and the expected return for a stock with β = 1.1.
Now, suppose that rf = _ 4% _, and E(Rm) = 8%; calculate the expected return for a stock with β = 0.9, and the expected return for a stock with β = 1.1.
Compare your expected returns in scenario 1 with those in scenario 2.