Assume that stock returns are generated by a two-factor model. The returns on three well-diversified portfolios, A,
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Question:
Assume that stock returns are generated by a two-factor model. The returns on three well-diversified portfolios, A, B and C, are given by the following representations:
=0.10+
1
rA=0.10+F1
=0.08+2
1
-
2
rB=0.08+2F1-F2
=0.05-0.5
1
+0.5
2
rC=0.05-0.5F1+0.5F2
- Discuss what the factor representations above imply for the variation and comovement in the three stock returns. Show how the returns of the stocks should be correlated between themselves.
- Find the portfolio weights that one must place on stocks A, B and C to construct pure tracking portfolios for the two factors (i.e. portfolios in which the loading on the relevant factor is +1 and the loadings on all other factors are 0).
- If one was to introduce a new portfolio, D, with loadings of +1 on both of the factors, what would the expected return on D have to be to rule out arbitrage?
- Explain the concepts of idiosyncratic risk and factor risk in the APT. What role does diversification play in the APT?
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