Suppose stock returns have a 2-factor structure. You observe a broad stock market portfolio A which earns on average 7.4% and has beta 0.5 on the first factor and beta 0.7 on the second factor; and another broad stock market portfolio B which earns on average 10.6% and has beta 1.2 on the first factor and beta 0.2 on the second factor. The risk free return is 3%. What do you expect to earn from a portfolio with beta 1 on the first factor and zero on the second factor?

Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
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Suppose stock returns have a 2-factor structure.
You observe a broad stock market portfolio A
which earns on average 7.4% and has beta 0.5 on
the first factor and beta 0.7 on the second factor;
and another broad stock market portfolio B which
earns on average 10.6% and has beta 1.2 on the
first factor and beta 0.2 on the second factor. The
risk free return is 3%. What do you expect to
earn from a portfolio with beta 1 on the first factor
and zero on the second factor?
Transcribed Image Text:Suppose stock returns have a 2-factor structure. You observe a broad stock market portfolio A which earns on average 7.4% and has beta 0.5 on the first factor and beta 0.7 on the second factor; and another broad stock market portfolio B which earns on average 10.6% and has beta 1.2 on the first factor and beta 0.2 on the second factor. The risk free return is 3%. What do you expect to earn from a portfolio with beta 1 on the first factor and zero on the second factor?
Expert Solution
Step 1

CAPM shows the relationship between the expected return, the market return, the risk-free return, and the systematic risk, which is denoted by the beta of the stock. It is one of the most widely used models in finance.

 

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