Question

(30) If the improving economy leads to an increase in investor risk tolerance and a corresponding reduction in the equity stock market risk premium, the CAPM implies that stock prices will be: (a) rising, to reduce expected rates of return to the new level of required rates of return

(b) remain constant, as changes in investor risk tolerance will not impact the financial market equilibrium

(c) declining, to increase expected rates of return to the new level of required rates of return

Answer 1

when investor risk tolerance increases , it leads to a reduction in the equity stock market premium, as given in the question. This is because as per CAPM , the risk premium increases when the investor is more risk-averse and also higher the risk , higher will be the expected return.

since the equity risk premium decreases , the required return as per CAPM will also decrease and this will lead to an increase in stock price

hence the correct option is a) rising, to reduce expected rates of return to the new level of required rates of return