2. Suppose there are two risky assets in the economy whose returns are related to a...

 

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2. Suppose there are two risky assets in the economy whose returns are related to a single risk factor by: F2 = H+Bf Let ry be the return on the risk-free asset. a. How do you eliminate the factor risk? b. If there is no arbitrage, and if B1 B2, show that there exists a parameter A (factor risk premium) for the linear pricing rule: c. Suppose that Hyr+B, j=1,2 where > 0, whereas the linear pricing rule holds for #41. Show how an arbi- trage profit can be made. Note: Assume that you have return and factor data, and you estimate mu_j and beta_j for j=1,2. For part a., construct the portfolio that eliminates beta risk using the data and estimates. Then for part b., use your solution from part a. to show that the riskless portfolio must have expected return r_f, and solve for lambda given mu_j, r_f, and beta_j for any asset j. 2. Suppose there are two risky assets in the economy whose returns are related to a single risk factor by: F2 = H+Bf Let ry be the return on the risk-free asset. a. How do you eliminate the factor risk? b. If there is no arbitrage, and if B1 B2, show that there exists a parameter A (factor risk premium) for the linear pricing rule: c. Suppose that Hyr+B, j=1,2 where > 0, whereas the linear pricing rule holds for #41. Show how an arbi- trage profit can be made. Note: Assume that you have return and factor data, and you estimate mu_j and beta_j for j=1,2. For part a., construct the portfolio that eliminates beta risk using the data and estimates. Then for part b., use your solution from part a. to show that the riskless portfolio must have expected return r_f, and solve for lambda given mu_j, r_f, and beta_j for any asset j.

Answer rating: 100% (QA)

a To eliminate factor risk we need to construct a portfolio that is uncorrelated with the factor We can achieve this by finding the weights of the two ... View the full answer