Question

For Security Market Line (SML) how is this affected by a rising inflation rate? Specifically, how would this impact lower and higher risk securities?

Also if risk aversion causes market premiums to increase (when static inflation) how would this impact lower and higher risk securities?

Answer 1

1. The security market line is a graphical representation of the CAPM that has required rate of return on the y axis and risk plotted on the x axis. The risk free rate as measured by government securities = r* + IP where r* is real inflation free rate and IP is the inflation premium. An increase in the inflation premium will cause an upward shift in the SML. The increase in risk free rate due to increase in inflation has an equal impact on the increase in rate of return on all classes of risk assets i.e. high risk and low risk. For example if the inflation premium rose by 2% then the risk free rate increases by 2% for all classes of securities.

2. The steeper the slope of the SML the higher the risk aversion i.e. the more the investor would like to be compensated for bearing the risk. If the investor has no risk bearing capacity then there is no risk premium and hence there is no shift in the SML i.e. a horizontal line is plotted for those unwilling to take risk. An increase in market premium for a risk averse investor the steeper the slope of the SML.