Question

1. What effect do increasing inflation expectations have on the required returns of investors in common stock?

2. Explain the specific relationship between risk and reward and why this relationship must be true.

Answer 1

1. Increasing inflation increases the required returns of stock. It has a positive relation with required returns of investors in common stocks. Higher the inflation , higher the risk and hence higher is the risk premium.

2. There is risk return trade off relationship. Higher is the risk, higher is the expectation of return.Risk and return are directly related.
This relationship must be true as investors won't expect low returns from high risk investments. In fact they would expected high return for high risk investments.