2 a diversified portfolio designed to be exposed to

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Unformatted text preview: .e. have zero sensitivity to each factor) is essentially risk-free and will therefore be priced such that it offers the risk-free rate as interest. 2. A diversified portfolio designed to be exposed to e.g. factor 1, will offer a risk premium that varies in proportion to the portfolio's sensitivity to factor 1. 5.7.2 Consumption beta If investors are concerned about an investment's impact on future consumption rather than wealth, a security's risk is related to its sensitivity to changes in the investor's consumption rather than wealth. In this case the expected return is a function of the stock's consumption beta rather than its market beta. Thus, under the consumption CAPM the most important risks to investors are those the might cutback future consumption. 5.7.3 Three-Factor Model The three factor model is a variation of the arbitrage pricing theory that explicitly states that the risk premium on securities depends on three common risk factors: a market factor, a size factor, and a book-tomarket factor: (35) Expected risk premium bmarket ˜ (rmarket fa cot r )  bsize ˜ (rsize factor )  bbook to  market ˜ (rbook to  market ) Where the three factors are measured in the following way: - Market factor is the return on market portfolio minus the risk-free rate Size factor is the return on small-firm stocks minus the return on large-firm stocks (small minus big) Book-to-market factor is measured by the return on high book-to-market value stocks minus the return on low b...
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This note was uploaded on 10/26/2012 for the course 19 19 taught by Professor - during the Spring '12 term at Sunway University College.

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