Question

(1) Suppose the risk-free rate goes up to 7%. What effect would higher interest rates have on the SML and on the returns required on high-risk and low-risk securities? (2) Suppose instead that investors’ risk aversion increased enough to cause the market risk premium to increase to 8%. (Assume the risk-free rate remains constant.) What effect would this have on the SML and on returns of high-and low-risk securities?

Answer 1

The SML depicts the CAPM model Graphically.

According to CAPM Model

Req Return = Rf + Beta(Rmarket - Rf)

Now Rf = Risk free rate of return or Intercept of SML on Y axis.

Thus if Rf increase the intercept will be shifted upwards and there will be shift in SML.

Suppose Rf = 4, Rm = 10 & beta = 0.8 of Low risk security and now Rf increases to 7, the req return will be 9.4%, whereas earlier it was 8.8% . Similarly for a high risk security having a beta of more than 1, the required return will increase.

However if there is a increase in market risk premium the intercept will remain same as Rf does not change, however the SML will bend upwards as Risk Premium Increases. Also the increase in required rate of return will be higher for High beta companies ( Riskier securities) as compare to low beta securities.