Assume that the following two-index model describes returns: E [ri] = rf+bid1 + bi2 2 Assume...

 

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Assume that the following two-index model describes returns: E [ri] = rf+bid1 + bi2 λ2 Assume that the following portfolios are observed: Portfolio A B C D Expected Return (%) 20 bil bi2 0 2 9 -1 1 2 1 15 28 3 2 1. According to APT, what is the expected return, factor-loading relationship for this market (do not consider D for this part)? Hint: Use the first three assets to set up a system of linear equations implied by the two-index model. Then solve for the unknown parameters (rf, A₁, A₂) and write down a formula for the expected returns of assets as a function of bi,k. 2. Now consider portfolio D with the characteristics from the table above. Is an arbitrage opportunity possible? If yes, then describe the arbitrage opportunity, i.e. construct an arbitrage portfolio. Hint: Use the pricing equation calculated in part 1. to compare the model implied expected return with the actual expected return. A potential arbitrage opportunity would have the same factor loadings as D but a different expected return. Assume that the following two-index model describes returns: E [ri] = rf+bid1 + bi2 λ2 Assume that the following portfolios are observed: Portfolio A B C D Expected Return (%) 20 bil bi2 0 2 9 -1 1 2 1 15 28 3 2 1. According to APT, what is the expected return, factor-loading relationship for this market (do not consider D for this part)? Hint: Use the first three assets to set up a system of linear equations implied by the two-index model. Then solve for the unknown parameters (rf, A₁, A₂) and write down a formula for the expected returns of assets as a function of bi,k. 2. Now consider portfolio D with the characteristics from the table above. Is an arbitrage opportunity possible? If yes, then describe the arbitrage opportunity, i.e. construct an arbitrage portfolio. Hint: Use the pricing equation calculated in part 1. to compare the model implied expected return with the actual expected return. A potential arbitrage opportunity would have the same factor loadings as D but a different expected return.

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Solution The twoindex model implies that the expected return of an asset is a function of its factor loading and the overall market factor loading Specifically the expected return of an asset is given ... View the full answer