Question

Which of the following is correct?

a.There is a negative (inverse) relationship between required rate of return on a stock and the price of the stock.

b.There is a positive (direct) relationship between required rate of return on a stock and the price of the stock.

c.There is no relationship between the required rate of return on a stock and the price of the stock.

d.None of the above

Answer 1

Answer :-

The statement that is correct is :-

There is a negative (inverse) relationship between required rate of return and price of stock.

Explanation :-

We know that

Price of stock = Expected Dividend / Required rate of return

Suppose that expected dividend is $100 and required rate of return is 8% so, the price of stock is $100/ 8% = $1250

Now, suppose the required rate increase to 10% , so, the price of stock would be $100 / 10% = $1,000

So, this formula shows that the price of stock falls when the required return increases and the price of stock increases when the required rate of return falls.

So, there is inverse relationship between price and required rate of return of stock.