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) The average required return on the market, rM, has remained constant, but the required returns have fallen for stocks that have betas greater than 1.0.
D) Required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas less than 1.0.
E) The required returns on all stocks have fallen by the same amount.

Question

Quizplus · Accepted Answer

When expected inflation and the market risk premium decline, the required return on equity (Ks) also declines. As a result, the required returns on all stocks would likely have fallen. However, since all stocks have positive betas, the fall in required returns would have been greater for stocks with higher betas. This is because the market risk premium is a key component of the CAPM equation, and stocks with higher betas are more sensitive to changes in the market risk premium.

Assume That in Recent Years Both Expected Inflation and the Market