Suppose that there are two independent economic factors, F1 and F2. The risk-fre

Question

Suppose that there are two independent economic factors, F1 and F2. The risk-free rate is 6%, and all stocks have independent firm-specific components with a standard deviation of 36%. Portfolios A and B are both well-diversified with the following properties: Expected Return Beta on F2 1.6 0.16 Portfolio Beta on F1 1.2 2.1 26% 23% What is the expected return-beta relationship in this economy? Calculate the risk-free rate, rf and the factor risk premiums, RP1 and RP2, to complete the equation below. (Do not round intermediate calculations. Round your answers to two decimal places.) rf RP1 RP2 0 0 0 0

Explanation / Answer

Risk free rate = 6%

Expected return of portfolio A = 6% + 1.2F1 + 1.6F2

26% = 6% + 1.2F1 + 1.6F2                                         

20% = 1.2F1 + 1.6F2 ------------------ (1)

Again

Expected return of portfolio B = 6% + 2.1F1 – 0.16F2

23% = 6% + 2.1F1 – 0.16F2                                         

17% = 2.1F1 – 0.16F2 ------------------- (2)

Now by solving equation 1 and equation 2

Multiply equation 2 by 10 and add both equation

20% + 170% = 1.2F1 + 21F1 + 1.6F2 – 1.8F2

190% = 22.20F1

                   F1 = 8.56%

Now Value of F2

27% = 1.2 × 8.56% + 1.6F2

1.8F2 = 16.73%

F2 = 9.29%

So equation for relation between beta of expected return is mention below:

Expected return = 6% + 8.56% × 1 + 9.29% × 2

Risk Free Rate = 6%

RP1 = 8.56% and

RP2 = 9.29%

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.