Question

Suppose there are two independent economic factors, M₁ and M₂. The risk-free rate is 4%, and all stocks have independent firm-specific components with a standard deviation of 41%. Portfolios A and B are both well diversified.

Portfolio	Beta on M1	Beta on M2	Expected Return (%)
A	1.8	2.3	31
B	2.2	-0.5	9

What is the expected return–beta relationship in this economy

Answer 1

Since, both the portfolios A and B are completely diversified. The expected return-beta relationship is that the higher the beta of the stock, the higher is the expected return. The stock with a higher beta is rewarded with a higher return. A stock with a lower beta, is compensated with lower return.

Portfolio A has two stocks M1 and M2 , both have higher betas, thus the higher returns.

Portfolio B's stocks have lower betas so, the expected return is also low.