134 CHAPTER 3 Risk and Returnvertical axis and returns on the market index were shown on the horizontal axis. The
slopes of the three lines in Figure 3-9 were used to calculate the three stocks’ betas,
and those betas were then plotted as points on the horizontal axis of Figure 3-12.- Riskless securities have bi0; therefore, rRFappears as the vertical axis intercept
in Figure 3-12. If we could construct a portfolio that had a beta of zero, it would
have an expected return equal to the risk-free rate. - The slope of the SML (5% in Figure 3-12) reflects the degree of risk aversion in
the economy—the greater the average investor’s aversion to risk, then (a) the
steeper the slope of the line, (b) the greater the risk premium for all stocks, and (c)
the higher the required rate of return on all stocks.^14 These points are discussed
further in a later section. - The values we worked out for stocks with bi0.5, bi1.0, and bi2.0 agree with
the values shown on the graph for rL, rA, and rH.
Both the Security Market Line and a company’s position on it change over time
due to changes in interest rates, investors’ aversion to risk, and individual companies’
betas. Such changes are discussed in the following sections.(^14) Students sometimes confuse beta with the slope of the SML. This is a mistake. The slope of any straight
line is equal to the “rise” divided by the “run,” or (Y 1 Y 0 )/(X 1 X 0 ). Consider Figure 3-12. If we let Y
r and Xbeta, and we go from the origin to b1.0, we see that the slope is (rMrRF)/(bMbRF)
(11%6%)/(10)5%. Thus, the slope of the SML is equal to (rMrRF), the market risk premium. In
Figure 3-12, ri6%5%bi, so an increase of beta from 1.0 to 2.0 would produce a 5 percentage point in-
crease in ri.
FIGURE 3-13 Shift in the SML Caused by an Increase in Inflation
0 0.5 1.0 1.5 2.0 Risk, b i
rM1 = 11
rRF2 = 8
rRF1 = 6
Required Rate
of Return (%)
rM2 = 13
r = 3
Original IP = 3%
Increase in Anticipated Inflation, ∆ IP = 2%
Real Risk-Free Rate of Return, r
SML 2 = 8% + 5%(bi)
SML 1 = 6% + 5%(bi)