Suppose that there are two independent economic factors, Fi and F2. The risk-free rate is 6%, and all stocks have independent firm-specific components with a standard deviation of 45%. The following are well- diversified portfolios: Portfolio Beta on F Beta on Expected Return 1.5 2.2 2.0 -0.2 31% 27% What is the expected return-beta relationship in this economy? Hint: Use the following equilibrium equations for multi-factor models: E(R.) = R, +B"(E(F) R.)+31(E(F) - R), and E\R,) = R, +B" (E(F) R.) +B"(E(F R,) Then, substitute for the factor risk premiums as: RP, = (E(F)- R,) and RP, = (E(F) - R,) This will reduce the problem to two-equations in two-unknowns, which can be solved using basic algebra. Once the factor risk premiums are resolved, one can write the risk-return relationship for any asset in the economy as: E(R)= R,+B (RP)+ B, (RP.)