Stock A has a beta of 0.8 and Stock B has a beta of 1.2. Fifty percent of Portfolio P is invested in Stock A and 50% is invested in Stock B. If the market risk premium (rM - rRF) were to increase but the risk-free rate (rRF) remained constant, which of the following would occur?
A) The required return will increase for both stocks but the increase will be greater for Stock B than for Stock A.
B) The required return will decrease by the same amount for both Stock A and Stock B.
C) The required return will increase for Stock A but will decrease for Stock B.
D) The required return on Portfolio P will remain unchanged.

Question

Quizplus · Accepted Answer

Since Portfolio P is invested 50% in Stock A and 50% in Stock B, the beta of the portfolio is [(0.5)(0.8)+(0.5)(1.2)] = 1.0, which is the beta of the market. Therefore, the required return on Portfolio P can be calculated as:

Rp = rRF + βp(rM - rRF)
Rp = rRF + (1.0)(rM - rRF)

If the market risk premium were to increase, then the value of (rM - rRF) would increase, causing the required return on Portfolio P to increase as well. However, since Stock B has a higher beta than Stock A, its required return will be more sensitive to changes in the market risk premium. Therefore, the increase in required return will be greater for Stock B than for Stock A. Choice A correctly reflects this.

Stock a Has a Beta of 0