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 25%. Portfolios A and B are well diversified. Portfolios A and B are both well diversified.

Portfolio Beta on M1 Beta on M2 Expected Return (%)

A 1.6 2.2 37

B 2.1 -0.6 15

What is the expected return–beta relationship in this economy?

Check the explanation

Explanation:

Expected return = risk free rate+M1 beta*M1 risk premium+M2 beta*M2 risk premium

37=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

answer; capital structure decision;