Question

The Security Market Line defines the required rate of return for a security to be worth buying or holding. The line, depicted in blue in the graph, is the sum of the risk-free return (rf in the slider) and a risk premium determined by the market-risk premium (RPM) multiplied by the security's beta coefficient for risk. Drag the rf slider below the graph to change the amount of the risk-free return. These changes reflect changes in inflation. Drag the RPM slider below the graph to change the relationship between a security's beta coefficient and the amount of the market risk premium. Drag left or right on the graph to move the cursor line to evaluate securities with different beta coefficients.

r=rRF+RPM∗beta=6%+5%∗1=6%+5.00%=11.00%r = r_{RF} + RP_M * beta = 6\% + 5\% * 1 = 6\% + 5.00\% = 11.00\%r=r​RF​​+RP​M​​∗beta=6%+5%∗1=6%+5.00%=11.00%

1. For a risk-free return rate of 5%, a market risk premium of 6%, what is the required rate of return for a security with a beta coefficient of 1.5?

1. 5%
2. 9%
3. 14%
4. cannot be determined

2. Changing the risk-free return (inflation)

1. Changes neither the y-intercept nor the slope of the security market line
2. Changes only the y-intercept of the security market line
3. Changes only the slope of the security market line
4. Changes both the y-intercept and the slope of the security market line

3. Changing the market risk premium

1. Changes neither the y-intercept nor the slope of the security market line
2. Changes only the y-intercept of the security market line
3. Changes only the slope of the security market line
4. Changes both the y-intercept and the slope of the security market line

4. True or False: If a company's beta doubles, its required return doubles.

1. True
2. False

Answer 1

Q1) C) 14%

Explanation:

Rate of return = risk free rate + beta (RPM)

= 5% + 1.5 (6%)

= 5% + 9%

= 14%

Q2) B) Changes only the y-intercept of the security market line

Explanation: The y intercept represents the expected return of the stock. Any change in risk free rate changes the expected return which is y -intercept.

Q3) C) Changes only the slope of the security market line

Explanation: Change in risk premium affects the slope of the SML. As the risk premium increases, it means the risk is more which affects the slope of security. In other words beta increases as the risk increases.

Q4) False

Explanation: The required return does not double when the beta doubles. For example , if the beta doubles in question 1 then the required return will be 23% .