Suppose there are two independent economic factors, M1 and M2. The risk-free rat

Question

Suppose there are two independent economic factors, M1 and M2. The risk-free rate is 7%, and all stocks have independent firm-specific components with a standard deviation of 51%. Portfolios A and B are both well diversified.

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(rP) =  % +  P1 +  P2

  Portfolio Beta on M1 Beta on M2 Expected Return (%) A 1.6          2.4         30                   B 2.3          –-0.7         11                  

Explanation / Answer

. E(rP) = rf + bP1[E(r1) - rf] + bP2[E(r2) – rf]}

P1= [E(r1) - rf]

P2= [E(r2) – rf]

30 = 7 + 1.6 * P1 + 2.4 * P2..........(1)

11 = 7 +2.3 * P1 + (-0.7)*P2.........(2)

Solving above two equations

23 = 1.6 * P1 + 2.4 * P2

4 =   2.3 * P1 + (-0.7)*P2

19 = -0.07p1 + 3.1P2

P1 = 6% , P2 = 5%

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