Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur? A) The required return on a stock with beta 1.0 will increase. B) The return on the market will remain constant. C) The return on the market will increase. D) The required return on a stock with beta

Question

Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur?
A) The required return on a stock with beta > 1.0 will increase.
B) The return on the market will remain constant.
C) The return on the market will increase.
D) The required return on a stock with beta < 1.0 will decline.

Quizplus · Accepted Answer

According to the capital asset pricing model (CAPM), the required return on a stock is equal to the risk-free rate plus the product of the stock's beta and the market risk premium. If the risk-free rate remains constant but the market risk premium declines, the required return on a stock with beta < 1.0 will decline. This is because the stock is less sensitive to changes in the market and therefore requires a lower return to compensate for its lower level of risk. Conversely, the required return on a stock with beta > 1.0 will increase, as it is more sensitive to changes in the market and requires a higher return to compensate for its higher level of risk. The return on the market itself may or may not change, but it is not relevant to the specific question being asked.

Assume That the Risk-Free Rate Remains Constant, but the Market