Question

The risk-free rate is 7%; Stock A has a beta of 2.0; Stock B has a beta of 1.0; and the market risk premium, r_M – r_RF, is positive. Which of the following statements is CORRECT?

		a. Stock A's required rate of return is twice that of Stock B.
		b. If Stock B's required return is 11%, then the market risk premium is 5%.
		c. If the risk-free rate remains constant but the market risk premium increases, Stock A's required return will increase by more than Stock B's.
		d. If Stock A's required return is 11%, then the market risk premium is 5%
		e. If the risk-free rate increases but the market risk premium stays unchanged, Stock A's required return will increase by more than Stock B's.

Answer 1

Correct answer: c. If the risk-free rate remains constant but the market risk premium increases, Stock A's required return will increase by more than Stock B's.

Equation for required return of stock under CAPM:

where,

R = Requried return of stock

rRF = Risk free rate

rM = Market return

rM-rRF = Market risk premium.

with above equation, we can say if risk free rate and market risk premium remain same then stock with higher beta would have higher rate of return.