Question

Stock LB has a beta of 0.5 and Stock HB has a beta of 1.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT? a. If both expected inflation and the market risk premium (rM − rRF) increase, the required return on Stock HB will increase by more than that on Stock LB. b. If expected inflation remains constant but the market risk premium (rM − rRF) declines, the required return of Stock LB will decline but the required return of Stock HB will increase. c. If expected inflation remains constant but the market risk premium (rM − rRF) declines, the required return of Stock HB will decline but the required return of Stock LB will increase. d. If both expected inflation and the market risk premium (rM − rRF) increase, the required returns of both stocks will increase by the same amount. e. Since the market is in equilibrium, the required returns of the two stocks should be the same.

Answer 1

Answer: a. If both expected inflation and the market risk premium (rM − rRF) increase, the required return on Stock HB will increase by more than that on Stock LB.

Step-by-step explanation:

According to the Capital Asset Pricing Model (CAPM) if both expected inflation and the market risk premium (rM − rRF) increase, the required return on Stock HB will increase by more than that on Stock LB.

To understand this, let's look at the CAPM formula.

Rr = rRF + b(rM - rRF)

Where,

Rr is Required Return

rRf is the risk free rate

b is beta and,

(rM − rRF) is market premium.

Now as you can see from that formula, if the market premium increases, the Required Return increases even more if the beta is higher because the product from a higher multiple will result in a higher required return.

For example,

Let say Market premium was 0 and risk free rate was 3%.

This would mean that both of them stocks would be at a require return of 3%.

Now let's say the market premium went up to 3.

The stock with 1.5 as beta will be,

= 3% + 1.5 (3)

= 7.5%

The stock with 0.5 beta will be,

= 3% + 0.5 (3)

= 4.5%

Notice how HB increased more than LB.