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Suppose there are two independent economic factors, M1 and M2. The risk-free rate is 5%, and...

Suppose there are two independent economic factors, M1 and M2. The risk-free rate is 5%, and all stocks have independent firm-specific components with a standard deviation of 52%. Portfolios A and B are both well diversified. Portfolio Beta on M1 Beta on M2 Expected Return (%) A 1.6 2.5 31 B 2.4 -0.7 12 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

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Answer #1
Expected return = risk free rate+M1 beta*M1 risk premium+M2 beta*M2 risk premium
31=5+1.6*M1 risk premium + 2.5*M2 risk premium
26=1.6*M1 risk premium + 2.5*M2 risk premium……(1)
12=5+2.4*M1 risk premium + -0.7*M2 risk premium
7=2.4*M1 risk premium + -0.7*M2 risk premium……(2)
Solving (1) & (2) simultaneously we get
M1 risk premium=5.01
M2 risk premium=7.18
Expected return Beta relationship is:
E{r}=5% + Beta M1*5.01 + Beta M2*7.18
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