Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occurσ 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 occurσ
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.
E) the required return on a stock with beta = 1.0 will not change.

Quizplus · Accepted Answer

When the market risk premium declines, the required return on stocks will also decline. Since stocks with beta < 1.0 are less risky than the market, the decline in the market risk premium will have a greater impact on their required return, causing it to decline. Therefore, the required return on stocks with beta < 1.0 will decline. The required return on a stock with beta > 1.0 will increase because they are riskier than the market and need to compensate investors for taking on more risk. The return on "the market" will remain constant because it represents an average of all stocks and does not change based on changes in the market risk premium. The required return on a stock with beta = 1.0 will also decline, but the decline will be smaller than the decline for stocks with beta < 1.0.

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