Suppose that a two-factor model, where the factors are the market return (Factor 1) and the...

 

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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 A B C Expected Return 19% 20% 6% Sensitivity to Factor Sensitivity to Factor 1 2 1.5 1 1 0 2 0 What are i) the risk premiums of the two factors and ii) the risk-free rate? b) Another well-diversified portfolio D has sensitivities 1 to factor 1 and 0.5 to factor 2, respectively. What is the APT-consistent expected return on Portfolio D? c) Suppose that Portfolio D's expected return is 12%. Given your answers above, strategize an arbitrage strategy involving Portfolios A, B, C, and D. (Hint: an arbitrage strategy requires no initial investment, has no risk and yet generates a positive return.) 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 A B C Expected Return 19% 20% 6% Sensitivity to Factor Sensitivity to Factor 1 2 1.5 1 1 0 2 0 What are i) the risk premiums of the two factors and ii) the risk-free rate? b) Another well-diversified portfolio D has sensitivities 1 to factor 1 and 0.5 to factor 2, respectively. What is the APT-consistent expected return on Portfolio D? c) Suppose that Portfolio D's expected return is 12%. Given your answers above, strategize an arbitrage strategy involving Portfolios A, B, C, and D. (Hint: an arbitrage strategy requires no initial investment, has no risk and yet generates a positive return.)

Answer rating: 100% (QA)

To solve this problem we will use the Arbitrage Pricing Theory APT to calculate the risk premiums of the two factors market return and growth rate of industrial production and the riskfree rate Then w... View the full answer