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Risk aversion and stocks' prices and earned rates of return

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In Chapter 7 (Unit 5), we saw that 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.

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The solution examines the effect of changes in risk aversion on stocks' prices and earned rates of returns.

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In Chapter 7 (Unit 5), we saw that 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.

Risk aversion: All else being equal, risk-averse investors prefer higher returns to lower returns and less risk to more risk. For any given rate of return, risk-averse investors prefer less risk. The risk-averse investors demand higher returns for investments with higher risk.
Required Return = Risk-free return + Risk Premium
Therefore Risk Premium = Required Return - Risk-free return
We can use Security Market Line (SML) to answer this question. Security Market Line (SML) is a plot in the risk return space: It is a plot of required return (plotted on Y axis) ...

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