How does the SML react to changes in the rate of interest, changes in the rate of inflation, and changing investor expectations?

The security market line refers to a line on a graph related to the capital asset pricing model. It defines the expected rate of return based on the risk-free rate and the expected market premium linked to the beta coefficient.

The security market line shifts upwards, parallel to the previous SML, if the rate of interest increases, and the SML shifts downwards if the interest rate decreases. Simply put, a change in the interest rate shifts the security market line.

The change in the rate of inflation will directly impact the interest rates. The increase in inflation also increases the interest rate, leading to upward shifts in the SML and vice versa.

Another factor affecting SML is risk preferences by investors; that is, if the investors become pessimistic or has risk aversion. If the investor becomes more risk-averse, then the slope of the security market line increases.