Security Market Line: Inflation Changes

Conceptual Overview: Explore how inflation changes the security market line.

The Security Market Line defines the required rate of return for a security to be worth buying or holding. The line, depicted in blue in the graph, is the sum of the risk-free return (rf in the slider) and a risk premium determined by the market-risk premium (RPM) multiplied by the security's beta coefficient for risk. Drag the slider below the graph to change the amount of the risk-free return. These changes reflect changes in inflation. Drag left or right on the graph to move the cursor to evaluate securities with different beta coefficients. In this graph, the market-risk premium is fixed at 5%.

r = r_{RF} + RP_M * beta = 6\% + 5\% * 1 = 6\% + 5.00\% = 11.00\%r=rRF+RPMbeta=6%+5%1=6%+5.00%=11.00%

0.00.51.01.52.02.505101520Beta CoefficientReq. Rate of ReturnRisk-Free Return = 6.0%Risk Premium = 5.00%1.011% 246810rf = 6

1. If the risk-free return were 4.0% and a security's beta coefficient were 2.0, what would be the required rate of return for the security?

4%

5%

10%

14%

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2. If the risk-free return (inflation) increases by 2 percentage points, the required rate of return

stays the same for all securities

increases the same 2 percentage points for all securities

increases for some securities and decreases for others depending on the beta coefficient

cannot be determined without more information

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3. If the risk-free return (inflation) increases by 2 percentage points, then for the security market line

both the y-intercept and the slope remain the same

the y-intercept changes and the slope remains the same

the y-intercept remains the same and the slope changes

both the y-intercept and the slope change

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