Use the letter in front of the statement to answer the questions that follow. Re

Question

Use the letter in front of the statement to answer the questions that follow. Read all the options first. The letter may be used to answer more than one question. It increases by 3% It decreases by 3% It increases, but not proportionately It decreases, but not proportionately No change, remains the same The SML shifts upward, but the slope remains constant The SML shifts downward, but the slope remains constant The SML pivots upward, and the slope becomes steeper The SML pivots downward, and the slope becomes flatter ASSUME THAT INFLATION IS EXPECTED TO INCREASE BY 3% THIS YEAR. What would happen to the risk free rate, r_rf What would happen to the market rate, r_m What would happen to the required rate, r What would happen to the slope of the SML NOW ASSUME THAT INFLATION WIL NOT INCREASE, BUT INVESTORS BECOME MORE AVERSE TO RISK, THUS REQUIRING AN ADDITIONAL 3% RETURN ON THEIR INVESTMENTS. What would happen to the risk free rate, r_rf What would happen to the market rate, r_m What would happen to the required rate, r What would happen to the slope of the SML

Explanation / Answer

(1) (F)

Higher risk-free rate will shift the Security market line (SML) upward, with a higher vertical intercept but no change in slope.

(2) (E)

Market rate doesn't change with inflation.

(3) (C)

Required rate, r = Risk free rate (RFR) + Beta x (Market rate - RFR)

r = RFR x (1 - Beta) + Beta x Market rate

So, as RFR increases by 3%, r increases but less than 3% (less than proportionately).

(4) (E)

Slope of SML doesn't change with inflation.

(5) (E)

(6) (E)

(7) (A)

(8) (H)

Keeping risk free rate unchanged, higher required return will make the SML pivot upward with increased slope.

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