Assume that in recent years both expected inflation and the market risk premium (rM - rRF) have declined. Assume also that all stocks have positive betas. Which of the following would be most likely to have occurred as a result of these changes?
A) The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas.
B) The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas.
C) Required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas less than 1.0.
D) The required returns on all stocks have fallen by the same amount.

Question

Quizplus · Accepted Answer

The market risk premium (rM - rRF) has declined, which means the required return on all stocks would have decreased. However, because all stocks have positive betas, the required return varies with the level of systematic risk (beta) of the stock. Therefore, the decline in required return would have been greater for stocks with higher betas as their required return is more sensitive to changes in the market risk premium. Hence, Option B is the most likely outcome.

Assume That in Recent Years Both Expected Inflation and the Market