Explanation:
In the CAPM, the Security Market Line (SML) represents the relationship between expected return and systematic risk for individual securities, where the slope of the line represents the market risk premium. The CAPM assumes that investors can borrow and lend at the risk-free rate, which may vary over time. Similarly, the market risk premium varies over times. Therefore, any change in the position or slope of the SML on the graph can represent changes in the risk-free rate, the market risk premium, or expected returns for a given level of systematic risk.
In a recession, investors generally become more risk-averse and demand higher returns for any given level of risk. This means that they would require a higher expected return on a stock to compensate them for the additional risk they are taking on. As a result, the SML is likely to increase (both shift upwards due to potentially higher risk-free rates depending on monetary policy, and steepen due to a higher market risk premium).
A is incorrect. A decrease in the SML would mean that expected returns are decreasing for a given level of risk, which is the opposite of what would happen in a recession.
C is incorrect. A recession would generally cause investors to demand higher returns for any given level of risk, which would cause a change in the position of the SML on the graph, rather than leaving it in the same position.
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Assume that the economy faces a crisis which leads to a recession. In such a scenario, the SML will most likely:
A
decrease.
B
increase.
C
remain the same.
D
It is impossible to determine the likely change in the SML with the given information.