Suppose the risk premiums in Example 7.8 were E(r_M) - r_f = 4% and E(r_TB) - r_f = 2%. What would be the equilibrium expected rate of return on Northeast Airlines?

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EXAMPLE 7.8 A Two-Factor SML Northeast Airlines has a market beta of 1.2 and a T-bond beta of .7. Suppose the risk premium of the market index is 6%, while that of the T-bond portfolio is 3%. Then the overall risk premium on Northeast stock is the sum of the risk premiums required as compensation for each source of systematic risk. The risk premium attributable to market risk is the stock's exposure to that risk, 1.2, multi- plied by the corresponding risk premium, 6%, or 1.2 x 6% = 7.2%. Similarly, the risk premium attributable to interest rate risk is .7 x 3% = 2.1%. The total risk premium is 7.2 + 2.1 = 9.3%. Therefore, if the risk-free rate is 4%, the expected return on the portfolio should be More concisely, 4.0% Risk-free rate +7.2% +Risk premium for exposure to market risk +2.1 +Risk premium for exposure to interest-rate risk 13.3% Total expected return E(r) = 4% + 1.2 x 6 % +.7 x 3% = 13.3%