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Chapter_14W_Key_Question_Solutions - 14W-11(Key Question...

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14W-11 ( Key Question ) Consider the Security Market Line (SML). What determines its vertical intercept? What determines its slope? And what will happen to an asset’s price if it initially plots onto a point above the SML? The vertical intercept is the risk-free interest rate (the rate on short-term U.S. government bonds) that is determined by Federal Reserve monetary policy. The slope of the SML depends on investor feelings about risk and the compensation they require for assuming that risk. If investors strongly dislike risk and require much greater compensation, the SML will be steeper than if investors are less concerned about risk. An asset plotting above the SML will be earning a higher rate than the average expected rate of return for similar investments. Investors will be attracted to that investment, and through the process of arbitrage, demand for the investment will increase, raising the price of asset and lowering its expected rate of return. 14W-8 (
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