Is it true? Please, explain in a VERY detailed way. If the price of money (e.g.,

Question

Is it true? Please, explain in a VERY detailed way.

If the price of money (e.g., interest rates and equity capital costs) increases due to an increase of anticipated inflation, the risk-free rate will also increase. If there is no change in investment aversion, then the market risk premium (r_M - r_RF) will remain constant. Also if there is change in stocks' betas, then the required rate of return on each stock as measured by will increase by the same amount as the increase in expected inflation.

Explanation / Answer

First 2 statements are true and third statement is not true.

Lets understand this by using 2 basic formulae.

1. CAPM model for calculating expected rate of return on a stock

Expected return = Risk free return + beta * (Market return - risk free return)

2.Nominal return = Real return + Inflation rate

From the second equation, it is very clear on nominal return increases with the increase in inflation, but not real return. So if inflation increases, all the interest rates will increase accordingly.

So if inflation increases, risk free rate will also increase

In this case, both market return and risk free return increase by same amount, (Equation 2), so there is no difference between r_M - r_RF

Using equation 1 and above statement, we can say that, if there is no change in Stock's beta, we can say that the required rate of return on each stock as measured by will increase by the same amount as the increase in expected inflation

But if Beta changes, expected rate of return will also change.

I hope I answered you questions clearly.

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