Question

A ______________ in the Treasury Bill (risk-free) rate ____________ the required rate of return of a...

A ______________ in the Treasury Bill (risk-free) rate ____________ the required rate of return of a common stock (i.e. based on CAPM).

A.

decrease: has no effect
B.

increase: decrease
C.

decrease: decrease
D.

decrease: increase
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Answer #1

Answer- The correct answer is C. Decrease: Decrease.

A Fall in Rf will pressure the market risk premium to Decrease. This is because as investors are able to get a Lower risk-free return, riskier assets will need to perform Lesser than before in order to meet investors’ new standards for required returns. Thus, they will demand a Lower rate of return to compensate them.

Assuming the market risk premium Decreases by the same amount as the risk-free rate does, the second term in the CAPM equation will remain the same. However, the first term will Decrease, thus Decreasing CAPM.

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