j. The yield curve is currently flat; that is, long-term Treasury bonds also have a 3.0% yield. Consequently, Merrill Finch assumes that the risk-free rate is 3.0%.

1. Write out the security market line (SML) equation; use it to calculate the required rate of return on each alternative, and graph the relationship between the expected and required rates of return.

2. How do the expected rates of return compare with the required rates of return?

3. Does the fact that Collections has an expected return that is less than the T-bill rate make any sense? Explain.

4. What would be the market risk and the required return of a 50-50 portfolio of High Tech and Collections? Of High Tech and U.S. Rubber?

k. 1. Suppose investors raised their inflation expectations by 3 percentage points over current estimates as reflected in the 3.0% risk-free rate. What effect would higher inflation have on the SML and on the returns required on high- and low-risk securities?