Suppose the following three-factor model holds: rit-rf=i + Bil(r1t - rf) + Bi2(r2t rf) + Bi(r3t-rf)...

  

Transcribed Image Text:

Suppose the following three-factor model holds: rit-rf=i + Bil(r1t - rf) + Bi2(r2t rf) + Bi(r3t-rf) + eit, where rit is the return on security i at time t, rf is the riskfree rate, rit, r2t, and r3t are the returns on the three factor portfolios at time t, Bil, Biz, and 13 are the sensitivities of i to the factors, and eit is the impact of unanticipated firm-specific events on i. (a) (4 points) A well-diversified portfolio P has p1 = 1, BP2 = 0.5, and p3 = -0.3. The riskfree rate rf is 4%. The expected factor returns are given by E(ri) = 5%, E(r2)=4%, and E(13) = 2%. Calculate P's expected return if no arbitrage opportunities exist. Suppose the following three-factor model holds: rit-rf=i + Bil(r1t - rf) + Bi2(r2t rf) + Bi(r3t-rf) + eit, where rit is the return on security i at time t, rf is the riskfree rate, rit, r2t, and r3t are the returns on the three factor portfolios at time t, Bil, Biz, and 13 are the sensitivities of i to the factors, and eit is the impact of unanticipated firm-specific events on i. (a) (4 points) A well-diversified portfolio P has p1 = 1, BP2 = 0.5, and p3 = -0.3. The riskfree rate rf is 4%. The expected factor returns are given by E(ri) = 5%, E(r2)=4%, and E(13) = 2%. Calculate P's expected return if no arbitrage opportunities exist.