Suppose that a two-factor model, where the factors are the market return (Factor 1) and the growth rate of industrial production (Factor 2), correctly describes the return generating processes of all assets and the corresponding two-factor APT correctly prices three well- diversified portfolios, A, B, and C. Portfolio Expected Return A B C 15% 20% 6% Sensitivity to Factor 1 1 1 0 Sensitivity to Factor 2 0 1 0 a. What are i) the risk premiums of the two factors and ii) the risk-free rate? b. Another well-diversified portfolio D has sensitivities 0 and 1 to factor 1 and factor 2, respectively. What is the APT-consistent expected return on Portfolio D? c. Suppose that Portfolio D's expected return is 10%. Given your answers above, form a portfolio consisting of Portfolios A, B, C, and D that generates an arbitrage profit. Express the other portfolio weights by using that of D as the numeraire 1 or -1. Show your workings.

Suppose that a two-factor model, where the factors are the market return (Factor 1) and the growth rate of industrial production (Factor 2), correctly describes the return generating processes of all assets and the corresponding two-factor APT correctly prices three well- diversified portfolios, A, B, and C. Portfolio Expected Return A B C 15% 20% 6% Sensitivity to Factor 1 1 1 0 Sensitivity to Factor 2 0 1 0 a. What are i) the risk premiums of the two factors and ii) the risk-free rate? b. Another well-diversified portfolio D has sensitivities 0 and 1 to factor 1 and factor 2, respectively. What is the APT-consistent expected return on Portfolio D? c. Suppose that Portfolio D's expected return is 10%. Given your answers above, form a portfolio consisting of Portfolios A, B, C, and D that generates an arbitrage profit. Express the other portfolio weights by using that of D as the numeraire 1 or -1. Show your workings.

Essentials Of Investments

11th Edition

ISBN:9781260013924

Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Chapter1: Investments: Background And Issues

Section: Chapter Questions

Problem 1PS

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