Could somebody give a scenario which results in a steaper Security Market line? I don’t understand how relaxing some of the assumptions of the Capital Market Theory make the line Steaper. One of the scenario give was relaxing the notion that investors are able to lend and borrow infinit amount at risk free rate. We all know that this is an imposible assumption. Now, if we relax this assumption, how will it make the CML or SML steaper? I was thinking that relaxing this assumption make the CML and SML less steaper because, instead of paying the risk free rate, you will be paying a higher interest rate for the same or more level of risk (the more you pay for borrowing, your effective return decreases). That effectively make the CML and SML less steaper than the one with the original assumption. Any help is appreciated.
any thoughts please?
the only time i can see steeper SML is if risk goes up.
pepp Wrote: ------------------------------------------------------- > the only time i can see steeper SML is if risk > goes up. Is your comment based on the notion that higher risks bring higher returns?
What you originally post is the correct logical behind the shape of the CML curve. The CML line goes to the market porfolio on the effecient frontier at one slope, showing return on lending, and goes to a flatter slope to the right of the market portfolio representing to cost to borrow which is greater.
The assumption of lend/borrow being the same gives one straight line. if you relax that assumption you’d have two Y intercepts. one for the risk free borrowing, and the other for risk free lending. This would result in two Efficient frontier tangent points, one being steeper than the other. Your investment returns will significantly differ as you can no longer borrow at the low interest (your assumption of less steep correct here) and the other is that you’d be lending at a lower interest then you’d borrow (steeper CML line). (look through lending-borrowing CML line [i.e lending at the left of tangent and borrowing at right of tangent)
jo_l Wrote: ------------------------------------------------------- > The assumption of lend/borrow being the same gives > one straight line. > if you relax that assumption you’d have two Y > intercepts. one for the risk free borrowing, and > the other for risk free lending. This would > result in two Efficient frontier tangent points, > one being steeper than the other. Your investment > returns will significantly differ as you can no > longer borrow at the low interest (your assumption > of less steep correct here) and the other is that > you’d be lending at a lower interest then you’d > borrow (steeper CML line). > The curve is steeper for the lending portion than the borrowing portion. You borrow at a higher rate ----> higher y intercept ----> lower slope and tangent with efficient frontier. > (look through lending-borrowing CML line [i.e > lending at the left of tangent and borrowing at > right of tangent)
that’s what i just said -_-