Question

The risk-free rate is expected to remain at current level in the coming years, while the market risk premium is expected to increase. Based on this forecast, which of the following statements is correct?

a. The required return will increase for all shares but will increase more for shares with higher betas.

b. The required return will increase for shares with a beta less than 1.0 and will decrease for shares with a beta greater than 1.0.

c. The required return for all shares will increase by the same amount.

d. The required return will increase for all shares but will increase less for shares with higher betas.

Answer 1

Option (a) is correct

As per CAPM equation, expected return of the stock is given by:

Expected or required rate of return = Risk free rate + Beta * (Market return - Risk free rate)

In the above equation, Market risk premium is given by:

Market risk premium = Market return - Risk free rate

If we look at the CAPM equation, if the market risk premium is increased, then, the required return will increase for all shares but will increase more for shares with higher beta.