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?
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
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?
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