Stock HB has a beta of 1.5 and Stock LB has a beta of 0.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT?
A) If expected inflation remains constant but the market risk premium (rM − rRF) declines, the required return of Stock LB will decline but the required return of Stock HB will increase.
B) If both expected inflation and the market risk premium (rM − rRF) increase, the required return on Stock HB will increase by more than that on Stock LB.
C) If both expected inflation and the market risk premium (rM − rRF) increase, the required returns of both stocks will increase by the same amount.
D) Since the market is in equilibrium, the required returns of the two stocks should be the same.
E) If expected inflation remains constant but the market risk premium (rM − rRF) declines, the required return of Stock HB will decline but the required return of Stock LB will increase.

Question

Quizplus · Accepted Answer

The required return of a stock is equal to the risk-free rate plus the product of the stock's beta and the market risk premium (rM − rRF). Therefore, the required return of Stock HB will be more sensitive to changes in the market risk premium than the required return of Stock LB due to their different betas. Thus, if both expected inflation and the market risk premium increase, the required return on Stock HB will increase by more than that on Stock LB.

Stock HB Has a Beta of 1