Assume that investors have recently become more risk averse, so the market risk premium has increased. Also, assume that the risk-free rate and expected inflation have not changed. Which of the following is most likely to occur?
A) The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium.
B) The required rate of return will decline for stocks whose betas are less than 1.0.
C) The required rate of return on the market, rM, will not change as a result of these changes.
D) The required rate of return for each individual stock in the market will increase by an amount equal to the increase in the market risk premium.

Question

Quizplus · Accepted Answer

An increase in the market risk premium means that investors expect higher returns for taking on more risk. As a result, the required rate of return for all stocks will increase by the same amount, which is equal to the increase in the market risk premium. Therefore, the required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium. Option B is incorrect because the required rate of return for stocks with betas less than 1.0 is already lower than the market required rate of return, and therefore a change in market risk premium would still result in an increase in required rate of return. Option C is incorrect because the market required rate of return does change as a result of changes in the market risk premium. Option D is incorrect because individual stocks will experience different changes in required rate of return based on their betas and other specific risk factors, not just based on the change in market risk premium.

Assume That Investors Have Recently Become More Risk Averse, So