Stock A has a beta of 0.8,Stock B has a beta of 1.0,and Stock C has a beta of 1.2.Portfolio P has equal amounts invested in each of the three stocks.Each of the stocks has a standard deviation of 25%.The returns on the three stocks are independent of one another (i.e. ,the correlation coefficients all equal zero).Assume that there is an increase in the market risk premium,but the risk-free rate remains unchanged.Which of the following statements is CORRECT?
A) The required return of all stocks will remain unchanged since there was no change in their betas.
B) The required return on Stock A will increase by less than the increase in the market risk premium,while the required return on Stock C will increase by more than the increase in the market risk premium.
C) The required return on the average stock will remain unchanged,but the returns of riskier stocks (such as Stock C)will increase while the returns of safer stocks (such as Stock A)will decrease.
D) The required returns on all three stocks will increase by the amount of the increase in the market risk premium.
E) The required return on the average stock will remain unchanged,but the returns on riskier stocks (such as Stock C)will decrease while the returns on safer stocks (such as Stock A)will increase.

Question

Quizplus · Accepted Answer

The required return on a stock is equal to the risk-free rate plus the product of the market risk premium and the stock's beta. Since the betas of the three stocks are different, their required returns will also be different. When the market risk premium increases, the required returns on all stocks will increase, but the increase will not be the same for all stocks. The required return on Stock A will increase by less than the increase in the market risk premium because its beta is less than 1.0. The required return on Stock C will increase by more than the increase in the market risk premium because its beta is greater than 1.0. Therefore, Choice B is correct.

Stock a Has a Beta of 0