Principles of Managerial Finance

242 PART 2 Important Financial Concepts

Required Return,

k

(%)

17

kz 1 = 16

15

km 1 = 14

kz = 13

12

km = 11

RF 1 = 10

9

8

RF = 7

6 5 4 3 2 1

0 .5 1.0 1.5 2.0

SML

bRF bm bz

Nondiversifiable Risk, b

SML 1

IP

Inc.

in IP

IP 1

k*

FIGURE 5.11

Inflation Shifts SML
Impact of increased inflation-
ary expectations on the SML

Figure 5.11 depicts the situation just described. It shows that the 3% increase

in inflationary expectations results in a parallel shift upward of 3% in the SML.

Clearly, the required returns on all assets rise by 3%. Note that the rise in the

inflation premium from 5% to 8% (IPtoIP 1 ) causes the risk-free rate to rise from

7% to 10% (RFtoRF 1 ) and the market return to increase from 11% to 14% (km

tokm 1 ). The security market line therefore shifts upward by 3% (SML to SML 1 ),

causing the required return on all risky assets, such as asset Z, to rise by 3%. It

should now be clear thata given change in inflationary expectations will be fully

reflected in a corresponding change in the returns of all assets, as reflected graph-

ically in a parallel shift of the SML.

Changes in Risk Aversion The slope of the security market line reflects the

general risk preferences of investors in the marketplace. As discussed earlier and

shown in Figure 5.1, most investors are risk-averse—they require increased

returns for increased risk. This positive relationship between risk and return is

graphically represented by the SML, which depicts the relationship between non-

diversifiable risk as measured by beta (xaxis) and the required return (yaxis).

The slope of the SML reflects the degree of risk aversion: the steeper its slope, the

greater the degree of risk aversion,because a higher level of return will be

required for each level of risk as measured by beta. In other words, risk premiums

increase with increasing risk avoidance.

Changes in risk aversion, and therefore shifts in the SML, result from chang-

ing preferences of investors, which generally result from economic, political, and

social events. Examples of events that increaserisk aversion include a stock mar-