# Question: Suppose that three stocks A B and C and two

Suppose that three stocks (A, B, and C) and two common risk factors (1 and 2) have the following relationship:

E(RA) = (1:1)λ1 + (0:8)λ2

E(RB) = (0:7)λ1 + (0:6)λ2

E(RC) = (0:3)λ1 + (0:4)λ2

a. If λ1 = 4% and λ2 = 2%, what are the prices expected next year for each of the stocks? Assume that all three stocks currently sell for $30 and will not pay a dividend in the next year.

b. Suppose that you know that next year the prices for Stocks A, B, and C will actually be $31.50, $35.00, and $30.50. Create and demonstrate a riskless, arbitrage investment to take advantage of these mispriced securities. What is the profit from your investment? You may assume that you can use the proceeds from any necessary short sale.

Problems 6 and 7 refer to the data contained in Exhibit, which lists 30 monthly excess returns to two different actively managed stock portfolios (A and B) and three different common risk factors (1, 2, and 3). (Note: You may find it useful to use a computer spreadsheet program such as Microsoft Excel to calculate your answers.)

E(RA) = (1:1)λ1 + (0:8)λ2

E(RB) = (0:7)λ1 + (0:6)λ2

E(RC) = (0:3)λ1 + (0:4)λ2

a. If λ1 = 4% and λ2 = 2%, what are the prices expected next year for each of the stocks? Assume that all three stocks currently sell for $30 and will not pay a dividend in the next year.

b. Suppose that you know that next year the prices for Stocks A, B, and C will actually be $31.50, $35.00, and $30.50. Create and demonstrate a riskless, arbitrage investment to take advantage of these mispriced securities. What is the profit from your investment? You may assume that you can use the proceeds from any necessary short sale.

Problems 6 and 7 refer to the data contained in Exhibit, which lists 30 monthly excess returns to two different actively managed stock portfolios (A and B) and three different common risk factors (1, 2, and 3). (Note: You may find it useful to use a computer spreadsheet program such as Microsoft Excel to calculate your answers.)

**View Solution:**## Answer to relevant Questions

a. Compute the average monthly return and monthly standard return deviation for each portfolio and all three risk factors. Also state these values on an annualized basis.b. Based on the return and standard deviation ...How might a jewelry store and a grocery store differ in terms of asset turnover and profit margin? Would you expect their return on total assets to differ assuming equal business risk? Discuss.A firm is earning 24 percent on equity and has low business and financial risk. Discuss why you would expect it to have a high or low retention rate.The DuPont formula defines the net return on shareholders’ equity as a function of the following components:• Operating margin• Asset turnover• Interest burden• Financial leverage• Income tax rateUsing only the ...Give an example of a stock where it would be appropriate to use the reduced form DDM for valuation and discuss why you feel that it is appropriate. Similarly, give an example and discuss a stock where it would not be ...Post your question