2) Suppose the Fama-French 3-factor model explains the expected returns on individual stocks: E[rd] - PtBin E[rm-rt] + BisMB E[rs-re] + BiHML E[TH-r] where rm-It is the excess return on the market, rs-re is the return on a portfolio of small cap stocks minus the return on a portfolio of large cap stocks (SMB means Small Minus Big), and rh-r is the return on a portfolio of high book-to-market ratio stocks minus the return on a portfolio of low book-to-market ratio stocks (HML means High minus Low). Suppose the factor risk premiums in this model are given by E[rm-rt] = 6% E[rs-re] = 8% E[TH-ri] = 7% A hedge fund (HF) has provided you with historical returns going back 15 years. The fund's average annual excess return was 25%, with a standard deviation of 50%. After running a multivariate regression of the fund's excess returns on the factors, you obtain the following factor loading estimates for the fund: BHE,m = 1, BHF,SMB = 0, BHF,HML = 3 a) Is there a reason to believe this fund had a bias towards investing in value (i.e., high book-to- market ratio) firms? How can you tell? (10 points) b) Suppose the market standard deviation is equal to 18%. Could you produce as high a Sharpe ratio as that of the fund by investing only in the risk free asset and the market portfolio? (10 points) c) Has the manager produced any alpha relative to the Fama-French 3-factor model? (10 points) 2) Suppose the Fama-French 3-factor model explains the expected returns on individual stocks: E[rd] - PtBin E[rm-rt] + BisMB E[rs-re] + BiHML E[TH-r] where rm-It is the excess return on the market, rs-re is the return on a portfolio of small cap stocks minus the return on a portfolio of large cap stocks (SMB means Small Minus Big), and rh-r is the return on a portfolio of high book-to-market ratio stocks minus the return on a portfolio of low book-to-market ratio stocks (HML means High minus Low). Suppose the factor risk premiums in this model are given by E[rm-rt] = 6% E[rs-re] = 8% E[TH-ri] = 7% A hedge fund (HF) has provided you with historical returns going back 15 years. The fund's average annual excess return was 25%, with a standard deviation of 50%. After running a multivariate regression of the fund's excess returns on the factors, you obtain the following factor loading estimates for the fund: BHE,m = 1, BHF,SMB = 0, BHF,HML = 3 a) Is there a reason to believe this fund had a bias towards investing in value (i.e., high book-to- market ratio) firms? How can you tell? (10 points) b) Suppose the market standard deviation is equal to 18%. Could you produce as high a Sharpe ratio as that of the fund by investing only in the risk free asset and the market portfolio? (10 points) c) Has the manager produced any alpha relative to the Fama-French 3-factor model? (10 points)