There are two independent economic factors, M1 and M2. The risk-free rate is 5%, and all stocks have independent firm-specific components with a standard deviation of 25%. Portfolios A and B are well diversified. Given the data below, which equation provides the correct pricing model?

A) E(r
P) = 5 + 1.12βP1 + 11.86βP2
B) E(r
P) = 5 + 4.96βP1 + 13.26βP2
C) E(r
P) = 5 + 3.23βP1 + 8.46βP2
D) E(r
P) = 5 + 8.71βP1 + 9.68βP2

Question

There are two independent economic factors, M1 and M2. The risk-free rate is 5%, and all stocks have independent firm-specific components with a standard deviation of 25%. Portfolios A and B are well diversified. Given the data below, which equation provides the correct pricing model?

A) E(r
P) = 5 + 1.12βP1 + 11.86βP2 
B) E(r
P) = 5 + 4.96βP1 + 13.26βP2 
C) E(r
P) = 5 + 3.23βP1 + 8.46βP2 
D) E(r
P) = 5 + 8.71βP1 + 9.68βP2

Quizplus · Accepted Answer

35 = 5 + 1.5 γ1 + 1.75 γ2; solve for γ1
γ1 = 20 - 1.1667γ2
20 = 5 + γ1 + .65γ2; sub in γ1
20 = 5 + 20 - 1.1667 γ2 + .65 γ2
γ2 = 9.68% γ1 = 8.71%

There Are Two Independent Economic Factors, M1 and M2