Suppose there are two independent economic factors, M 1 and M 2 . The risk-free rate is 7%, and all stocks have independent firm-specific components with a standard deviation of 50%. Portfolios A and B are both well diversified.

Portfolio Beta on M 1 Beta on w 2 Expected Return (%)
A 1.8 2.1 40 B 2.0 ⫺0.5 10 What is the expected return–beta relationship in this economy?
Challenge LO.1