Assume that to cool off the economy and decrease expectations for inflation,the Federal Reserve tightened the money supply,causing an increase in the risk-free rate,r_RF.Investors also became concerned that the Fed's actions would lead to a recession,and that led to an increase in the market risk premium, (r_M - r_RF).Under these conditions,with other things held constant,which of the following statements is most correct? A) The required return on all stocks would increase by the same amount. B) The required return on all stocks would increase,but the increase would be greatest for stocks with betas of less than 1.0. C) Stocks' required returns would change,but so would expected returns,and the result would be no change in stocks' prices. D) The prices of all stocks would decline,but the decline would be greatest for high-beta stocks. E) The prices of all stocks would increase,but the increase would be greatest for high-beta stocks.

Question

Quizplus · Accepted Answer

When the Federal Reserve tightens the money supply, it generally leads to higher interest rates (increased risk-free rate) and, in this scenario, an increased market risk premium due to fears of a recession. Both of these actions would lead to an increase in the required return on stocks. Since the required return is inversely related to a stock's price (all else being equal), stock prices would decline. High-beta stocks, which are more sensitive to market changes, would experience greater declines in their prices due to their higher sensitivity to changes in the market risk premium.

Assume That to Cool Off the Economy and Decrease Expectations