Stock A has a beta of 1.2 and a standard deviation of returns of 14%. Stock B ha

Question

Stock A has a beta of 1.2 and a standard deviation of returns of 14%. Stock B has a beta of 1.8 and a standard deviation of returns of 18%. If the risk free rate of return increases and the market risk premium remains constant, then _________.

A) The required rate of return on Stock B will increase more than the required rate of return on stock A.
B) The required returns on stocks A and B will both increase by the same amount.
C) The required returns on stocks A and B will remain the same
D) The required return on stock A will increase more than the required return on Stock B.

Explanation / Answer

TO CLARIFY LETS TAKE AN EXAMPLE

LET RISK FREE INTEREST Rf = 5%

MARKET RISK PRIMIUM IS = 10%

REQUIRED RETURN Ke OF STOCK A = Rf + BETA * MARKET RISK PRIMIUM

= 5% + 1.2 * 10%

   = 17%

REQUIRED RETURN Ke OF STOCK B = Rf + BETA * MARKET RISK PRIMIUM

= 5% + 1.8 * 10%

   = 23%

NOW THE Rf INCEREASED TO 8%

REQUIRED RETURN Ke OF STOCK A = Rf + BETA * MARKET RISK PRIMIUM

= 8% + 1.2 * 10%

   = 20%

REQUIRED RETURN Ke OF STOCK B = Rf + BETA * MARKET RISK PRIMIUM

= 8% + 1.8 * 10%

   = 26%

WE CAN CLEARLY OBSERVE THAT THE DIFFRENCE OF REQUIRED RETURN BETWEEN TWO STOCK IS SAME IN THE THE ABOVE TWO CASES.

SO THE REQUIRED RETURN OF STOCK A & B WILL INCEREASE BY THE SAME AMOUNT IS THE CORRECT ANSWER.

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.