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Demystifying SML: Risk, Return, and Market Valuation Insights

Chapter 17, Problem 9

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QUESTION:

What determines the vertical intercept of the Security Market Line (SML)? What determines its slope? And what will happen to an asset’s price if it initially plots onto a point above the SML?

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Demystifying SML: Risk, Return, and Market Valuation Insights
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Uncover the essentials of the Security Market Line (SML) in finance. Explore the concept of risk and return, market risk premiums, and how undervalued assets are spotted in this insightful video.

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QUESTION:

What determines the vertical intercept of the Security Market Line (SML)? What determines its slope? And what will happen to an asset’s price if it initially plots onto a point above the SML?

ANSWER:

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The vertical intercept of the Security Market Line (SML) is determined by the risk-free rate of return. The risk-free rate represents the return an investor can earn with certainty by investing in a risk-free asset, such as government bonds. The vertical intercept of the SML indicates the expected return of a well-diversified portfolio with zero systematic risk (beta) concerning the risk-free rate.

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