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    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 Preview

    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 ...

    Solution Summary

    This solution discusses how the security market lines reacts to changes in rates of interest and inflation and changing investor expectations.