Gapenski, Chapter 10 Problems set 10.4

Suppose that the risk-free rate, RF, was 8 percent and the required rateof return on the market, R(Rm), was 14 percent.

a. Write out the security market line (SML) equation and explain each item.

b. Plot the SML on a sheet of paper,

c. Suppose the inflation expectations increase such that the risk free rate, RF, increase to 10 percent and the required rate of return on the market, R(Rm), increases to 16 percent. Write out and plot the new SML.

d. Return to the original assumption in this problem. Now, suppose that investors' risk aversion increases and the required rate of return on the market, R(Rm), increases to 16 percent. (There is no change in the risk-free rate because RF reflects the required rate of return on a riskless investment.) Write out and plot the new SML