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Unformatted text preview: THE ECONOMICS OF FINANCIAL MARKETS R. E. BAILEY Solution Guide to 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 j A 1.2 0.4 16% B 0.8 1.6 26% r 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; j is the expected rate of return on each of the assets; and r is the riskfree rate of return. (a) If the APT holds in this market, calculate the risk premia corresponding to the two fac tors. Answer : The APT predicts: i r = 1 b i 1 + 2 b i 2 for i = A, B, (1) where 1 , 2 are the two risk premia corresponding to factors 1 and 2, respectively. Hence: A r = 1 b A 1 + 2 b A 2 B r = 1 b B 1 + 2 b B 2 Substituting: . 16 . 06 = 1 1 . 2 + 2 . 4 . 26 . 06 = 1 . 8 + 2 1 . 6 Hence: . 10 = 1 . 2 1 + 0 . 4 2 . 20 = . 8 1 + 1 . 6 2 Solving (by whatever method you choose) gives: 1 = 0 . 05 , 2 = 0 . 10 . (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....
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 Spring '11
 CRABBE

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