Chapter 8 Questions

Chapter 8 Questions - a = 1-a A-a B . Also, the response of...

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THE ECONOMICS OF FINANCIAL MARKETS R. E. BAILEY Exercises for Chapter 8 Factor models and the arbitrage pricing theory 1. The following information is provided for a stock market in which asset returns respond to two factors: Asset b j 1 b j 2 μ j A 1.2 0.4 16% B 0.8 1.6 26% r 0 0 0 6% Notation : b j 1 and b j 2 for j = A, B denote the responses of the rates of return on assets A and B to the factors; μ j is the expected rate of return on each of the assets; and r 0 is the risk-free rate of return. (a) If the APT holds in this market, calculate the risk premia corresponding to the two fac- tors. (b) Construct a portfolio which gives unit weight to the first factor and zero weight to the second factor. Hence provide an interpretation for the risk premia in the APT. Hint: If a portfolio P has weights equal to a A and a B in assets A and B , respectively, then the proportion in the risk-free asset, a 0 , is equal to:
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Unformatted text preview: a = 1-a A-a B . Also, the response of the return on P to the factors is given by: b P 1 = a A b A 1 + a B b B 1 b P 2 = a A b A 2 + a B b B 2 . Finally, note that the expected return on P , μ P , is given by: μ P = a r + a A μ A + a B μ B . (c) Asset C also traded in this market and yields an average return of 12% with b C 1 = 1 . and b C 2 = 0 . 5 . What inferences would you draw about the asset market from this information? 2. Explain the implications of assuming that asset returns are determined according to a three-factor model in which each factor is the rate of return (in excess of the risk-free rate) on a given portfolio. What considerations should determine how the three given portfolios (factors) are defined? *****...
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This note was uploaded on 03/21/2011 for the course ECON 6120 taught by Professor Crabbe during the Spring '11 term at University of Ottawa.

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