Assume That to Cool Off the Economy and Decrease Expectations

Assume that to cool off the economy and decrease expectations for inflation, the Federal Reserve tightened the money supply, causing an increase in the risk-free rate, rRF. Investors also became concerned that the Fed's actions would lead to a recession, and that led to an increase in the market risk premium, (rM - rRF) . Under these conditions, with other things held constant, which of the following statements is most correct?

A) The required return on all stocks would increase by the same amount.
B) The required return on all stocks would increase, but the increase would be greatest for stocks with betas of less than 1.0.
C) Stocks' required returns would change, but so would expected returns, and the result would be no change in stocks' prices.
D) The prices of all stocks would decline, but the decline would be greatest for high-beta stocks.
E) The prices of all stocks would increase, but the increase would be greatest for high-beta stocks.

Correct Answer:

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