Question

Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur? a. The required return on a stock with beta = 1.0 will not change. b. The required return on a stock with beta > 1.0 will increase. c. The return on "the market" will remain constant. d. The return on "the market" will increase. e. The required return on a stock with a positive beta < 1.0 will decline

Answer 1

Answer: The required return on a stock with a positive beta < 1.0 will decline.

This is the correct answer because when the market risk premium declines  

the required return on stocks with any positive beta will decline. The reason for this is that Beta is the sensitivity of the stock to the market premium so if the market premium declines, if the beta is positive the return will decline

Example Capm RR= RF+B(RP)

If the RF= 5%

RP=5%

Beta of stock is 0.5

The required return on the stock will be 0.05+0.5(0.05)=0.075=7.5%

If the RP declines and goes to 2%

Then Required return will be equal to 0.05+0.5(0.02)=0.07=7%

Explanation: