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 of all stocks will increase by the amount of the increase in the risk-free rate.
B) 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.
C) Since the overall return on the market stays constant, the required return on each individual stock will remain constant.
D) 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.

Question

Quizplus · Accepted Answer

When the risk-free rate increases, the required return on all assets increases because the risk-free rate is the minimum return investors require for investing in a risky asset. However, if the market risk premium declines, the required return for risky assets (i.e. the market) decreases. The net effect is that the overall required return on the market (rM) remains constant.

The Capital Asset Pricing Model (CAPM) states that the required return on an asset is equal to the risk-free rate plus the product of the market risk premium and the asset's beta. Therefore, if the risk-free rate increases and the market risk premium declines, the impact on an asset's required return will depend on the asset's beta.

For stocks that have a beta less than 1.0, their required return will decrease because the market risk premium decline outweighs the increase in the risk-free rate. For stocks that have a beta greater than 1.0, their required return will increase because the increase in the risk-free rate outweighs the market risk premium decline. Therefore, the correct answer is D.

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