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 Capital Asset Pricing Model (CAPM) states that 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. Therefore, if the market risk premium declines, and everything else remains constant, the required return on all stocks will decline. However, if the risk-free rate increases, the required return on low-beta stocks will be impacted more than on high-beta stocks. Thus, 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.

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