Stock HB has a beta of 1.5 and Stock LB has a beta of 0.5. The market is in equilibrium, with required returns equalling expected returns. Which of the following statements is correct?
A) If expected inflation remains constant but the market risk premium (rM - rRF) declines, the required return of Stock LB will decline but the required return of Stock HB will increase.
B) If both expected inflation and the market risk premium (rM - rRF) increase, the required return on Stock HB will increase by more than that of Stock LB.
C) If both expected inflation and the market risk premium (rM - rRF) increase, the required returns of both stocks will increase by the same amount.
D) If expected inflation remains constant but the market risk premium (rM - rRF) declines, the required return on Stock HB will decline but the required return of Stock LB will increase.

Question

Quizplus · Accepted Answer

The required return of a stock is calculated as r = rRF + β(rM - rRF), where rRF is the risk-free rate, β is the stock's beta, and rM - rRF is the market risk premium.

If the market risk premium (rM - rRF) declines, the required return of a stock will decrease. Therefore, in choice A, the required return of Stock LB will decrease, but the required return of Stock HB will increase. This is because Stock HB has a higher beta than Stock LB, so it is more sensitive to changes in the market risk premium.

If both expected inflation and the market risk premium (rM - rRF) increase, the required return of both stocks will increase. However, Stock HB has a higher beta than Stock LB, so it is more sensitive to changes in the market risk premium. Therefore, the required return on Stock HB will increase more than that of Stock LB, making choice B the correct answer.

Choice C is incorrect because the two stocks have different betas, which means they will have different required returns even if the market risk premium and expected inflation change by the same amount.

Choice D is incorrect because if the market risk premium declines, the required return on Stock HB will also decrease because the stock has a nonzero beta.

Stock HB Has a Beta of 1