Question

2. Consider a financial market composed of only two risky assets (which are imperfectly correlated). Risky asset 1 has beta equal to B.-1.7 and expected return equal to E(n)-10%. Risky asset 2 has beta equal to B2-0.7 and expected return equal to E(T2)-7%. Find expected return on the market portfolio

Answer 1

Expected Ret = Risk Free Ret + Beta [ Market ret - Risk Free Rate ]

Risky Asset1:

Rf + 1.7 [ Risk Premium ] = 10%

Risky Asset 2:

Rf + 0.7 [ Risk Premium ] = 7%

On solving thos eq

1 [ Risk Premium ] = 3%

Risk Premium = 3%

Put the same in Equation 1

Rf + 1.7 [ 3% ] = 10%

Rf + 5.1% = 10%

Rf = 10% -5.1%

= 4.9%

Rm - Rf = 3%

Rm = 3% + Rf

= 3% + 4.9%

= 7.9%

Expected Market ret is 7.9%

note: Rm - Rf is Risk Premium