(a.) Estimating a single index model with four observations has revealed the following results: Rit =...
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(a.) Estimating a single index model with four observations has revealed the following results: Rit = 2.473 + 1.011 Rmt + Eit The four market returns used in the estimation were: 9%, 5%, 1% and 3% and the four residuals are 0.4286, 0.4725, 4.4615 and 3.5604. Calculate the total amount of risk, the common factor risk and the firm specific risk of asseti. [40 marks] (b.) Suppose you have two risky assets and asset 2 is 30% more risky than asset 1. Assume that asset 1 has a beta of 1 and the expected returns of the two assets are 5% (asset 1) and 8% (asset 2). (i.) if the riskfree rate is 1% and asset 1 is correctly priced according to the CAPM, explain what you would do. (ii.) if asset 1 and asset 2 are correctly priced according to the CAPM, what would the riskfree rate be? [30 marks] (c.) Carefully explain why the CAPM proposes only common factor risk should be priced. [30 marks]
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Let s address each part of your question a Calculate the total amount of risk the common factor risk and the firm specific risk of asset i The given single index model for asset i is Rit 2 473 1 011Rm... View the full answer
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