Assume that the risk-free rate remains constant, but that the market risk premium (Rm-rf) declines. Which of the following is likely to occur?Group of answer choicesThe required return on a share with a beta = 1.0 will increaseThe required return on a share with a beta > 1.0 will increase.The required return on a share with a beta < 1.0 will decreaseThe required return on a share with a beta > 1.0 will declineThe required return on a share with a beta = 1.0 will remain the same.
Question
Assume that the risk-free rate remains constant, but that the market risk premium (Rm-rf) declines. Which of the following is likely to occur?Group of answer choicesThe required return on a share with a beta = 1.0 will increaseThe required return on a share with a beta > 1.0 will increase.The required return on a share with a beta < 1.0 will decreaseThe required return on a share with a beta > 1.0 will declineThe required return on a share with a beta = 1.0 will remain the same.
Solution
The required return on a share with a beta = 1.0 will remain the same. This is because the beta of 1.0 means that the security's price will move with the market. So, if the market risk premium declines, the required return on the share will not change as it moves in line with the market.
The required return on a share with a beta > 1.0 will decline. A beta greater than 1.0 indicates that the security's price will be more volatile than the market. So, if the market risk premium declines, the required return on these shares will also decline as they are expected to move more than the market.
The required return on a share with a beta < 1.0 will decrease. A beta less than 1.0 indicates that the security's price will be less volatile than the market. So, if the market risk premium declines, the required return on these shares will also decrease as they are expected to move less than the market.
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