Question

Which of the following statements is correct? The security market line:

Answer 1

The market risk premium calculates the slope of the security market line.

What is market risk premium?

A risk premium is the higher rate of returns you can expect from riskier investments like stocks compared to risk-free investments like government bonds. The pricing model for capital assets is graphically represented by the security market line (SML), a line drawn on a graph. The SML can be used to assist in trying to compare an investment product's rate of return towards its level of risk.

Numerous exogenous factors can have an impact on the slope of a security market line. For instance, the economy's real interest rate could change, inflation might rise or fall, there could be a recession, and investors could start to take less risk generally.

In other words, higher risk also comes with higher rewards because more systematic risk is linked to higher expected returns for securities. The linear relationship also explains why security market line is indeed a straight line.

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