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?

Short answer

The risk-free interest rate determines the vertical intercept of the SML, and the risk premium determines the slope of the SML. The asset price will increase at a point above the SML.

Step-by-step solution

Step 1. Vertical intercept determining factor of the SML

The Security Market Line (SML) represents an investment’s average expected rate of return for the risk levels associated with the investment. The average expected rate of return is determined by the risk-free interest rate on an asset and the risk premium.

The risk-free interest rate is the compensation for time preference. It is paid on short-term government bonds and remains fixed. So it does not alter the average expected rate of return. Thus, it is the factor that determines the y-intercept of SML.

Step 2. Slope determining factor of the SML

The risk premium on investment is the compensation for the non-diversifiable risk involved with the investment. It varies with each investment. The risk premium size depends on beta. Beta value is plotted on the horizontal axis, and the average expected rate of return is plotted on the vertical axis. With an increase in beta value, the average expected rate of return increases.

Thus, a high beta value or risk premium value inspires the investor’s preference for investment. Hence, the slope of SML is determined by the risk premium.

Step 3. Impact of a point above SML on the asset price

A point above the SML indicates an extremely high return on investment for a given beta level. It will pull up the demand for the particular asset. Higher demand for the asset will increase the asset price.