Stock A has a beta of 1.2 and a standard deviation of returns of 14%. Stock B ha
ID: 2662690 • Letter: S
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.