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Unformatted text preview: asset is worth less if inflation increases. Alternatively, the rate of return on bonds increases as market interest rates always increase if inflation increases. The return on stocks must increase if bond returns increase. A higher return on stocks can be achieved only if stock prices fall. (e) Now, r M = 13%, so r S = 6.46 + 1.4(13 6.46) = 15.62%. If investors become less risk averse regarding stocks, less compensation is required to hold stocks. So, r S decreases. Now, P = 2.16/(.1562 - .08) = $28.35. Price increases because investors are now willing to pay more for stocks since they are viewed as being less risky. (f) The actual return must fall from 18.60% to 17.02%. In order to have a lower return, the purchase price must increase. So, at this moment the stock is undervalued....
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This note was uploaded on 11/06/2010 for the course ECON 11 taught by Professor Tsuash during the Spring '10 term at University of San Francisco.
- Spring '10