Security Market Line and Financial Changes
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How does the security market line react to changes in the rate of interest, changes in the rate of inflation, and changing investor expectations?
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Solution Summary
This solution discusses how the security market lines reacts to changes in rates of interest and inflation and changing investor expectations.
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Security Market Line (SML) is an equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities.
SML Equation:
Required return on Stock i = Risk free rate + (Market risk premium) (Stock i's beta)
ri = rRF + (rM - rRF) bi
Interest amounts to "rent" on borrowed money, or the price of money. Thus, rRF is the price of money to a riskless borrower. Risk-free rate is measured by the rate on U.S. Treasury securities, which is called the ...
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