Stock HB has a beta of 1.5 and Stock LB has a beta of 0.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT?
A) If expected inflation remains constant but the market risk premium (rM − rRF) declines, the required return of Stock LB will decline but the required return of Stock HB will increase.
B) If both expected inflation and the market risk premium (rM − rRF) increase, the required return on Stock HB will increase by more than that on Stock LB.
C) If both expected inflation and the market risk premium (rM − rRF) increase, the required returns of both stocks will increase by the same amount.
D) Since the market is in equilibrium, the required returns of the two stocks should be the same.

Question

Quizplus · Accepted Answer

The security market line (SML) equation is r = rRF + β(rM − rRF). According to the equation, the required return of a stock is positively related to its beta. Therefore, Stock HB with a higher beta carries more market risk and will have a higher required return than Stock LB with a lower beta when all other factors remain constant.

In choice A, if the market risk premium declines while expected inflation remains constant, both stocks' required returns will decline. However, the decline in Stock LB will be greater than that in Stock HB because of their different betas.

In choice B, if both expected inflation and the market risk premium increase, the required return on Stock HB will increase more than that on Stock LB due to their different betas.

In choice C, although both stocks will face an increase in required returns, the increase will not be the same because of their different betas.

In choice D, the market equilibrium does not imply that all stocks should have the same required returns. Rather, the required return of a stock is determined by its beta and the market risk premium.

Stock HB Has a Beta of 1