The Security Market Line (SML) relates risk of individual securities to their required rate of return. If investors conclude that the inflation rate is going to increase, which of the following change would occur?
A) The market risk premium would increase.
B) The beta of the stock would increase.
C) The slope of the SML would become steeper.
D) The standard deviation of the stock would increase.
E) The required return of an average stock would increase.

Question

Quizplus · Accepted Answer

If investors conclude that the inflation rate is going to increase, they would require a higher rate of return on their investments to compensate for the decrease in purchasing power. This would increase the required return of an average stock, causing a shift upward along the SML. The market risk premium, beta, and standard deviation of the stock may remain the same, as they are not directly influenced by changes in inflation expectations. The slope of the SML would also not change, as it is determined by the market risk premium and beta.

The Security Market Line (SML) Relates Risk of Individual Securities