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Ans_Problem_Set_8_09

Ans_Problem_Set_8_09 - Princeton University Department of...

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Princeton University Department of Economics Economics 362 Fall Term 2009-2010 Problem Set 8 – Multi-Factor Models Use the following to answer questions 1-2: Consider the multifactor APT. There are two independent economic factors, F 1 and F 2 . The risk-free rate of return is 6%. The following information is available about two well- diversified portfolios: Portfolio β on F 1 β on F 2 Expected Return A 1.0 2.0 19% B 2.0 0.0 12% 1. Assuming no arbitrage opportunities exist, the risk premium on the factor F 1 portfolio should be __________. A) 3% B) 4% C) 5% D) 6% E) none of the above Answer: A Rationale: 2A: 38% = 12% + 2.0(RP1) + 4.0(RP2); B: 12% = 6% + 2.0(RP1) + 0.0(RP2); 26% = 6% + 4.0(RP2); RP2 = 5; A: 19% = 6% + RP1 + 2.0(5); RP1 = 3%. 2. Assuming no arbitrage opportunities exist, the risk premium on the factor F 2 portfolio should be ___________. A) 3% B) 4% C) 5% D) 6% E) none of the above Answer: C Rationale: See solution to previous problem.
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3. Discuss the advantages of arbitrage pricing theory (APT) over the capital asset pricing model (CAPM) relative to diversified portfolios.
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