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Impact of Market Risk Premium on Price of Common Stock

Course: Investment Planning
Lesson 14: Evaluating Portfolio Performance

Student Question:

I’ve seen this question come up a couple times, but can’t seem to grasp the answer.

“If the Market Risk Premium were to increase, all other things
being equal, the value of common stock would…”

The answer is “decrease”, but that makes no sense to me because
of the CAPM equation:
R = RF + B(RM-RF)

Market Risk Premium is defined to be “RM-RF”, so if that number
is larger, then the Return must be larger. How can it decrease?

Thanks,
Craig

Instructor Response:

Craig,

You are wise to refer back to CAPM whenever there’s a question like this.  CAPM is a portfolio management tool.  In this question we’re relying upon CAPM to tell us the maximum price to pay for a security.  If the market risk premium increases, then our required rate of return increases. Assuming all other variables such as PE ratio remain constant, the only way we can increase return is to pay less for the security.  Increases in the risk-free rate of return has the same effect, i.e., raising the required rate of return.  This is why equity securities prices may decline as the Fed raises interest rates.

Hope that helps!

Bruce