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Chapter 17: Q9. (page 368)

What determines the vertical intercept of the Security Market Line (SML)? What determines its slope? And what will happen to an asset鈥檚 price if it initially plots onto a point above the SML?

Short Answer

Expert verified

The risk-free interest rate determines the vertical intercept of the SML, and the risk premium determines the slope of the SML. The asset price will increase at a point above the SML.

Step by step solution

01

Step 1. Vertical intercept determining factor of the SML

The Security Market Line (SML) represents an investment鈥檚 average expected rate of return for the risk levels associated with the investment. The average expected rate of return is determined by the risk-free interest rate on an asset and the risk premium.

The risk-free interest rate is the compensation for time preference. It is paid on short-term government bonds and remains fixed. So it does not alter the average expected rate of return. Thus, it is the factor that determines the y-intercept of SML.

02

Step 2. Slope determining factor of the SML

The risk premium on investment is the compensation for the non-diversifiable risk involved with the investment. It varies with each investment. The risk premium size depends on beta. Beta value is plotted on the horizontal axis, and the average expected rate of return is plotted on the vertical axis. With an increase in beta value, the average expected rate of return increases.

Thus, a high beta value or risk premium value inspires the investor鈥檚 preference for investment. Hence, the slope of SML is determined by the risk premium.

03

Step 3. Impact of a point above SML on the asset price

A point above the SML indicates an extremely high return on investment for a given beta level. It will pull up the demand for the particular asset. Higher demand for the asset will increase the asset price.

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Most popular questions from this chapter

Suppose that the Federal Reserve thinks that a stock market bubble is occurring and wants to reduce stock prices. What should it do to interest rates?

The U.S. government issues longer-term bonds with horizons of up to 30 years. Why do 20-year bonds issued by the U.S. government have lower rates of return than 20-year bonds issued by corporations? And which do you think has the higher rate of return, longer-term U.S. government bonds or short-term U.S. government bonds? Explain.

Corporations often distribute profits to their shareholders in the form of dividends, which are quarterly payments sent to shareholders. Suppose that you have the chance to buy a share in a fashion company called Rogue Designs for \(35 and that the company will pay dividends of \)2 per year on that share. What is the annual percentage rate of return? Next, suppose that you and other investors could get a 12 percent per year rate of return on the stocks of other very similar fashion companies. If investors care only about rates of return, what should happen to the share price of Rogue Designs? (Hint: This is an arbitrage situation.)

Identify each of the following investments as either an economic investment or a financial investment.

a. A company builds a new factory.

b. A pension plan buys some Google stock.

c. A mining company sets up a new gold mine.

d. A woman buys a 100-year-old farmhouse in the countryside.

e. A man buys a newly built home in the city.

f. A company buys an old factory.

If the Fed increases interest rates, the SML will shift _______ and asset prices will _______.

  1. down; rise

  2. down; fall

  3. up; rise

  4. up; fall
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