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solution

Suppose that the risk-free rate, RF, were 8 percent and the required rate of return on the market, R(RM), were 14 percent.

a. Write out the Security Market Line (SML), and explain each term. b. Plot the SML on a sheet of paper.

c. Suppose that inflation expectations increase such that the risk-free rate, RF, increases to 10 percent and the required rate of return on the market, R(RM), increases to 16 percent. Write out and plot the new SML.

d. Return to the original assumptions in this problem. Now, suppose that investors’ risk aversion increases and the required rate of return on the market, R(RM), increases to 16 percent. (There is no change in the risk-free rate because RF reflects the required rate of return on a riskless investment.) Write out and plot the new SML.

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