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Chapter 17: Q10. (page 369)

If the Fed increases interest rates, the SML will shift _______ and asset prices will _______.

  1. down; rise

  2. down; fall

  3. up; rise

  4. up; fall

Short Answer

Expert verified

The correct option is (d): up; fall

Step by step solution

01

Step 1. Explanation

SML vertical intercept shifts upward with the increase in the rate of interest by the Fed. The rate of return on a risky asset will increase, leading to a decrease in price as the price is inversely related to its return. Thus, the asset price will fall. Hence, the SML will shift up, and asset prices will fall.

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Most popular questions from this chapter

Suppose that you invest $100 today in a risk-free investment and let the 4 percent annual interest rate compound. Rounded to full dollars, what will be the value of your investment 4 years from now?

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?

If we compare the betas of various investment opportunities, why do the assets that have higher betas also have higher average expected rates of return?

Asset X is expected to deliver 3 future payments. They have present values of, respectively, \(1,000, \)2,000, and \(7,000. Asset Y is expected to deliver 10 future payments, each having a present value of \)1,000. Which of the following statements correctly describes the relationship between the current price of Asset X and the current price of Asset Y?

  1. Asset X and Asset Y should have the same current price.

  2. Asset X should have a higher current price than Asset Y.

  3. Asset X should have a lower current price than Asset Y.

Next, consider another pair of assets, C and D. Asset C will make a single payment of \(150 in one year while D will make a single payment of \)200 in one year. Assume that the current price of C is \(120 and that the current price of D is \)180.

c. What are the rates of return of assets C and D at their current prices? Given these rates of return, which asset should investors buy and which asset should they sell?

d. Assume that arbitrage continues until C and D have the same expected rate of return. When arbitrage ends, will C and D have the same price?

Compare your answers to questions a through d before answering question e.

e. We know that arbitrage will equalize rates of return. Does it also guarantee to equalize prices? In what situations will it equalize prices?
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