Question: Assume that the latest CPI data suggests that the annual U.S. inflation in 2013 would fall to to 1.5% (vs. previous estimate of 2.1%). What will happen to the stock returns required by investors according to the CAPM model?
1. Since the inflation risk is spurious, the CAPM-based returns do not change with the change in expected inflation.
2. The CAPM would predict that the returns on every stock rise as expected inflation falls.
3. Because most rational investors hold diversified portfolios, they are automatically protected against the inflation risk and thus there should be no relation between CAPM returns and expected inflation.
4. The CAPM would indicate that the returns on every stock fall by the amont of inflation differential (i.e., parallel downward shift in SML).