Increase in Investor Inflation Expectations

C

Parallel shifts in the SML result from changing market conditions (such as an increase in expected inflation). When inflation expectations increase, investors want to be compensated for the increased risk and to insure that their purchasing power is not eroded. Thus, the SML shifts upward, increasing the expected return at each level of risk.

The SML will shift downward in response to decreasing inflation expectations, decreased economic growth, and expanding capital markets. Changes in slope cause the SML to rotate. The slope of the SML will change in response to changes in attitudes of investors toward risk that affects the market risk premium. If there is an increase in the market risk premium, the SML will rotate counterclockwise about the risk free rate. If there is a decrease in the market risk premium, the

SML will rotate clockwise about the risk free rate.