Question

Suppose there are two independent economic factors, M₁ and M₂. The risk-free rate is 6%, and all stocks have independent firm-specific components with a standard deviation of 54%. Portfolios A and B are both well diversified.

Portfolio	Beta on M1	Beta on M2	Expected Return (%)
A	1.7	2.0	33
B	1.9	-0.8	14

What is the expected return–beta relationship in this economy? (Do not round intermediate calculations. Round your answers to 2 decimal places.)

Expected return–beta relationship E(r_P) =__ % + ___ β_P1 + ___ β_P2

Answer 1

let Risk Premium of Economic Factor M, = RPA let Risk Premium of Economic Factor M₂ = RP. Now, as pes APT equahon, PORTFOLIO A 33 %. = 6 % + (1.7 RP, ) + ( 2.0 RP.) — 0 PORTFO210 B 14). = 6 % + 1.9AP. + (-0.8 RP) — ☺ solving Equation 0 and ☺ we get : Risk Premium for M, = 7.28% Risk Premium for M2 = 7.31 % oo Expected Return – Beta Relationship is : Elre) = 6 % + (Bp. * 7.28%) + (Bra x 7.31 %)