Effect of Risk-Free Rate Increase on CAPM Expected Return

Very Hard Portfolio Risk And Return Capital Asset Pricing Model

During a recent investment seminar, an investment manager discussed the Capital Asset Pricing Model (CAPM) and its implications for constructing an optimal portfolio. The manager presented the expected return for a stock based on its systematic risk (beta), as well as the market return and the risk-free rate. They stated: "If the risk-free rate increases while the market return remains constant, the expected return for a stock with a beta of 1.2 will also change. Based on this principle, which of the following statements about the expected return according to the CAPM is correct?"

The expected return will decrease as the risk-free rate increases, given that beta remains constant.

The expected return will remain the same because the beta of the stock is unchanged.

The expected return will increase, as it is directly related to changes in the risk-free rate.

Hint

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