Question

QUESTION 20

1. Assume that investors have recently become more risk averse (less risk tolerant), so the market risk premium (r _m - r _RF) has increased. Also, assume that the risk-free rate and expected inflation have not changed. Which of the following is most likely to occur?

   	1.	The required rate of return on a riskless bond will decline.
   	2.	The required rate of return for an average stock (beta =1) will increase by an amount equal to the increase in the market risk premium.
   	3.	The required rate of return will decline for stocks whose betas are less than 1.0.
   	4.	The required rate of return on the market, rM, will not change as a result of these changes.
   	5.	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.

Answer 1

To answer this question we first need to look at the CAPM equation used to solve for the expected return of stock:

so the (rm-rRF) stands for the return_market-return_{Risk free} or the market risk premium

We can simply see that if beta is 1 then the expected return, also known as the required return, will increase by the increase in market risk premium, so statement 2 is correct.

Option 4 is incorrect as it says that required rate won't change but it does, and statement 5 is incorrect because it doesnt consider the beta value. If beta is lower than 1 then the increase in required return will be lower

Option 3 is incorrect because required rate will increase whether beta is less that or greater than 1, but if beta is negative, then the required return increases but negative beta is not common.

Option 1 is incorrect because the return on the riskless bond is the rRF and that remains unchanged.