Question

What impact would the following changes have on the security market line and therefore on the required return for a given level of risk? (a) an increase in inflationary expectations, (b0 Investors become less risk-averse.

Answer 1

security market line:

the security market line begins with the risk free rate, and it moves upward to the right. as the risk on an investment increases, it is expected that the return on the investment will increase. an investor with a low risk profile would be at a point in the beginning of the SML ,and an investor with a high risk profile will choose a point at the right of the SML . The slope of the SML is the risk premium, the risk premium would increase if the required return by the investors increases for a given level of risk. if the required return required by the investor increases, the slope changes as well.

Due to a change in the inflationary expectations, the rate of rf increases. thus the slope of the SML shifts up UPWARDS PARALLEL TO THE ORIGINAL,and the investors have to be compensated with a higher rate of return. Therefore, the required return increases.

Investors become less risk averse: more risky investors are located at the right of the SML. So, as the investors become less risk averse so the slope of the SML will DECREASE,as the required return by the investor falls. R(m) falls. the required return falls.