Question

A security market line has an intercept and slope of 1% and 9%. This implies that

A. the risk-free interest rate is 1%

B. the market risk premium is equal to 9%

C. the required market return is 10%

D. all of the above

Answer 1

Security Market Line (SML)

Intercept = 1% and Slope = 9%

SML shows the relationship between Capital Asset Pricing Model (CAPM) return and Beta of various investments or portfolio.

CAPM = Risk free rate + Beta ( Return from market - Risk free rate)

Any equation is expressed as,

y = ax+b

CAPM return = Risk Free rate + Slope * Beta of Security

CAPM return = Risk Free rate + (Change in Y / Change in X) * Beta of Security

CAPM return = Risk Free rate + (Return from Market - Risk Free Rate) / (1) * Beta of Security

Please note that beta of market is assumed to be 1.

Intercept reflects the Risk free rate i.e. 1%

Slope is change in Y i.e. Return from Market - Risk Free rate = Market Risk Premium = 9%

So, Return from Market = 10%

( Please refer the diagram for better clarity)

A. the risk-free interest rate is 1%

B. the market risk premium is equal to 9%

C. the required market return is 10%

D. all of the above

(In case any query, please comment. I will reply in the comments)