Assume that in recent years both expected inflation and the market risk premium (r_M − r_RF) have declined.Assume also that all stocks have positive betas.Which of the following would be most likely to have occurred as a result of these changes? A) The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas. B) The average required return on the market, r_M, has remained constant, but the required returns have fallen for stocks that have betas greater than 1.0. C) Required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas less than 1.0. D) The required returns on all stocks have fallen by the same amount. E) The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas.

Question

Quizplus · Accepted Answer

When expected inflation and the market risk premium decline, the required return on stocks also declines. However, stocks with higher betas are considered to be riskier and thus, their required return falls more than stocks with lower betas due to a greater decrease in the market risk premium component of the cost of equity. Therefore, the required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas.

Assume That in Recent Years Both Expected Inflation and the Market