Suppose you develop a 2-factor model for expected stock returns of the following form: ra rf = a + 1(rm rf) + 2(rz rf) + (1) You also calculate the following quantities: 2() = .15,2m = .08 and 2z = .03

Question 5.2: Now suppose a fellow analyst believes your model can be improved upon by adding a third factor (rb rf). Your boss looks over the new model and notices that the beta to the new factor, 3 is negative. He says that this cant possibly help because the first two factor betas were positive and adding a third factor beta that is negative would lower the predictive power of the model. Is your boss correct or incorrect? Prove your answer.