Assume that the risk-free rate, rRF, increases but the market risk premium, (rM − rRF), declines, with the net effect being that the overall required return on the market, rM, remains constant Which of the following statements is CORRECT?
A) The required return will decline for stocks that have a beta less than 1.0 but will increase for stocks that have a beta greater than 1.0.
B) Since the overall return on the market stays constant, the required return on each individual stock will also remain constant.
C) The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0.
D) The required return of all stocks will fall by the amount of the decline in the market risk premium.
E) The required return of all stocks will increase by the amount of the increase in the risk-free rate.

Question

Quizplus · Accepted Answer

The overall required return on the market is composed of the risk-free rate plus the market risk premium, so if the risk-free rate increases but the market risk premium declines, then the impact on the overall required return on the market is uncertain. However, the CAPM equation tells us that the required return on a stock is equal to the risk-free rate plus the stock's beta multiplied by the market risk premium. If the overall required return on the market remains constant, then a decline in the market risk premium will be offset by an increase in the risk-free rate. This means that the required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0. This is because low beta stocks are less sensitive to market movements and investors will demand a higher return to compensate for the increase in the risk-free rate, while high beta stocks are more sensitive to market movements and investors will be willing to accept a lower return as the market risk premium declines.

Assume That the Risk-Free Rate, RRF, Increases but the Market