Assume that investors have recently become more risk averse, so the market risk premium has increased. Also, assume that the risk-free rate and expected inflation have not changed. Which of the following is most likely to occur?
A. The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium.
B. The required rate of return will decline for stocks whose betas are less than 1.0.
C.The required rate of return on the market, rM, will not change as a result of these changes.
D.The required rate of return for each individual stock in the market will increase by an amount equal to the increase in the market risk premium.
E.The required rate of return on a riskless bond will decline.
To determine the most likely outcome, let's analyze the information provided.
1. Investors have become more risk averse, leading to an increase in the market risk premium.
2. The risk-free rate and expected inflation have not changed.
Given these factors, let's consider each option:
A. The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium.
This could be a possibility since investors becoming more risk averse would demand a higher return for taking on additional risk.
B. The required rate of return will decline for stocks whose betas are less than 1.0.
A higher market risk premium could imply a higher required rate of return for all stocks, regardless of their beta. Therefore, this option is unlikely.
C. The required rate of return on the market, rM, will not change as a result of these changes.
Since the market risk premium has increased, it is unlikely that the required rate of return on the market would remain unchanged. Therefore, this option is not likely.
D. The required rate of return for each individual stock in the market will increase by an amount equal to the increase in the market risk premium.
This option is similar to option A, suggesting that the required rate of return for each individual stock would increase in line with the increase in market risk premium. It is a possible outcome given the information provided.
E. The required rate of return on a riskless bond will decline.
The risk-free rate has not changed in this scenario, so the required rate of return on a riskless bond would not be expected to decline. Therefore, this option is unlikely.
Considering all the factors, the most likely outcome is A: The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium.