Assume that in recent years both expected inflation and the market risk premium (r_M - r_RF) 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 would have fallen, but the decline would have been greater for stocks with lower betas. B)The required returns on all stocks would have fallen, but the fall would have been greater for stocks with higher betas. C)Required returns would have increased for stocks with betas greater than 1.0 but would have declined for stocks with betas less than 1.0. D)The required returns on all stocks would have fallen by the same amount.

Question

Quizplus · Accepted Answer

When expected inflation and market risk premium decline, the required return on stocks also declines. Since all stocks have positive betas, the required return on higher beta stocks is more sensitive to changes in the market risk premium than lower beta stocks. Therefore, the fall in required return would be greater for stocks with higher betas. Hence, option B is the correct choice.

Assume That in Recent Years Both Expected Inflation and the Market