From Schweser Qbank: John Smith uses SML to make investment decisions. His firm incurs 2 percent transaction costs on all purchases. How does the existence of the 2 percent transaction cost change the intercept and slope of the SML for stock purchases faced by John Smith’s firm? A intercept increases by 2%, slope increases by 2% B intercept increases by 2%, no change to slope C No change to intercept, slope increases by 2% D No change to intercept, no change to slope Answer: B My question: what is the logic for the intercept increasing by 2% rather than decreasing by 2%? Is it that securities that price slightly above their SML (say, by up to 2%), which would normally get purchased (which purchase would thereby remove the excess return opportunity), will no longer get purchased, because the excess return opportunity is offset by the transaction cost? And therefore, the SML becomes a band that goes up as high as 2% higher than the line itself? Or does the SML actually just shift up by the 2%? Intercept is showing by what increment the overall line will shift, correct? So I would think that if the firm incurs transaction costs on purchases, then for securities that plot slightly above the SML by up to 2%,
it will have to earn 2% + risk free rate to be considered as an investment option and therefore the securities on the SML must earn this amount to be properly priced