Assume that the risk-free rate,r_RF,increases but the market risk premium, (r_M - r_RF),declines with the net effect being that the overall required return on the market,r_M,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 also 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. E) The required return of all stocks will fall by the amount of the decline in the market risk premium.

Question

Quizplus · Accepted Answer

When the risk-free rate increases, the required return of all stocks increases, but when the market risk premium declines, the required return decreases. The net effect will depend on the relative magnitudes of these changes, but if the overall required return on the market remains constant, then the declining market risk premium must offset the increase in the risk-free rate. Therefore, the required return will increase for stocks that have a beta less than 1.0 (i.e., less risky than the market) because their risk premium will increase to compensate for the lower market risk premium, but it will decline for stocks that have a beta greater than 1.0 (i.e., more risky than the market) because their risk premium will decrease due to the lower market risk premium.

Assume That the Risk-Free Rate,rRF,increases but the Market Risk Premium

Assume That the Risk-Free Rate,r_RF,increases but the Market Risk Premium