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.
E) The required rate of return on a riskless bond will decline.

Question

Quizplus · Accepted Answer

When investors become more risk-averse, the market risk premium increases, which will cause a corresponding increase in the required rate of return for all stocks (as measured by the CAPM equation). Therefore, choice A is the most likely outcome. Choice B is incorrect because the required rate of return will increase for all stocks, regardless of their betas. Choice C is incorrect because the CAPM equation shows that the required rate of return is a function of the risk-free rate, the market risk premium, and the stock's beta, so if the market risk premium increases, the required rate of return on the market will also increase. Choice D is incorrect because the increase in the required rate of return will not necessarily be the same for every stock in the market. Choice E is also incorrect because the risk-free rate and expected inflation are assumed to be constant.

Assume That Investors Have Recently Become More Risk Averse, So