A security has a loading on the market factor of 1.5, a loading on the size factor
Question:
A security has a loading on the market factor of 1.5, a loading on the size factor of 0.0 and a loading on the value factor of 1.0. The mean return of the security is 8.5%, the risk-free rate is 1.5%, the market risk premium is 4.0%, the size premium is 2.5% (mean return of a portfolio long on small firms and short on large firms), the value premium is 5.0% (mean return of a portfolio long on firms with high book-to-market ratios and short on firms with low book-to-market ratios).
(a) What sort of firm does the firm issuing this security seem to be?
(b) Find the cost of capital based on this security if (i) the CAPM holds, and (ii) the Fama-French 3-factor model holds.
(c) Calculate the security’s alpha if (i) the CAPM is supposed to hold, and (ii) the Fama-French 3-factor model is supposed to hold.
(d) Provide several possible explanations for the alpha found in (c) for the Fama-French 3-factor model.
Expert Answer:
