During the coming year, the market risk premium (rM − rRF), is expected to fall, while the risk-free rate, rRF, is expected to remain the same. Given this forecast, which of the following statements is CORRECT?
A) The required return will increase for stocks with a beta less than 1.0 and will decrease for stocks with a beta greater than 1.0.
B) The required return on all stocks will remain unchanged.
C) The required return will fall for all stocks, but it will fall more for stocks with higher betas.
D) The required return for all stocks will fall by the same amount.
E) The required return will fall for all stocks, but it will fall less for stocks with higher betas.

Question

Quizplus · Accepted Answer

The market risk premium is the difference between the expected return on the market and the risk-free rate. If the market risk premium is expected to fall, this means that investors will require a lower return to invest in risky assets such as stocks. However, the degree to which the required return will fall will depend on the stock's beta. Stocks with higher betas are considered more risky, so investors will still require a higher expected return compared to less risky stocks. Therefore, the required return will fall for all stocks, but it will fall more for stocks with higher betas.

During the Coming Year, the Market Risk Premium (RM −