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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. During a recession, investors typically become more risk-averse, which increases the market risk premium. This leads to a steeper slope for the SML, effectively causing the required returns (the SML itself for risky assets) to increase.
Q.2389 Consider the graph presented below. The line represents the security market line derived from the Capital Asset Pricing Model (CAPM).
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.
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