# Question

If the risk-free rate of return is 4 percent and the expected rate of return on the market portfolio is 10 percent.

a. Graph the security market line (SML). Also, calculate and label the market risk premium on the graph.

b. Using your graph from question a, identify the expected rates of return on a portfolio with beta of .4 and a beta of 1.8, respectively.

c. Now assume that because of a financial crisis the economy slows down and anticipated inflation drops. As a result, the risk-free rate of return drops to 2 percent and the expected rate of return on the market portfolio drops to 8 percent. Draw the resulting security market line.

d. Now assume that because of economic fears, investors have become more risk averse, demanding a higher return on all assets that have any risk. This results in an increase in the expected rate of return on the market portfolio to 12 percent (with the risk-free rate equal to 4 percent). Draw the resulting SML. What can you conclude about the effect of a financial crisis on expected rates of return?

a. Graph the security market line (SML). Also, calculate and label the market risk premium on the graph.

b. Using your graph from question a, identify the expected rates of return on a portfolio with beta of .4 and a beta of 1.8, respectively.

c. Now assume that because of a financial crisis the economy slows down and anticipated inflation drops. As a result, the risk-free rate of return drops to 2 percent and the expected rate of return on the market portfolio drops to 8 percent. Draw the resulting security market line.

d. Now assume that because of economic fears, investors have become more risk averse, demanding a higher return on all assets that have any risk. This results in an increase in the expected rate of return on the market portfolio to 12 percent (with the risk-free rate equal to 4 percent). Draw the resulting SML. What can you conclude about the effect of a financial crisis on expected rates of return?

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