Question

consider a well-diversified portfolio, a, in a two-factor economy. the risk-free rate is 6%, the risk premium on the first factor portfolio is 4% and the risk premium on the second factor portfolio is 3%. if portfolio a has a beta of 1.2 on the first factor and .8 on the second factor, what is its expected return

Answer 1

Answer:

The expected return for a well diversified portfolio is 13.20%

Explanation:

The formula for multi-factor Capital Asset Pricing Model is given below

Expected return=Rf+Beta1*(RP1)+Beta2*(RP2)

Rf is the risk free rate of return is 6%

Beta1 is 1.2

RP1 is the risk premium on the first factor is 4%

Beta2 is 0.8

RP2 is the risk premium on the first factor is 3%

Expected return=6%+(1.2*4%)+(0.8*3%)

Expected return is 13.20%

This expected return on well diversified portfolio would have a return close 13.20%

A non-diversified factor 1 only investment would have 10.8%( 6%+(1.2*4%)) which lower compared to a diversified portfolio

A non-diversified factor 2 only investment would have 8.40%( 6%+(0.8*3%)) which lower compared to a diversified portfolio