Question

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

Answer 1

If the certainty equivalent is less than the expected value,the investor is risk averse.If investor is risk averse, it means that risky investments must offer higher expected returns than less risky investment to induce people invest in them.

In this question, investors have recently become more risk averse so the market risk premium has increased and risk-free rate and expected inflation have not changed.In this situation, the required rate of return will increase by an equal amount to the increase in maket risk premium.