Purchase Solution

Three Factor Model

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Suppose stock returns can be explained by the following three factor model:
Ri = Rf + B1(F1) + B2(F2) - B3(F3)

Assume there is no firm-specific risk. The information for each stock is presented here:

Beta1 (B1) Beta2 (B2) Beta3 (B3)
Stock A 1.45 0.80 0.05
Stock B 0.73 1.25 -0.20

The risk premiums for the factors are 5.3 percent, 3.9 percent, and 4.2 percent, respectively. If you create a portfolio with 60 percent invested in stock A and the remainder in stock B, and the risk-free rate is 2 percent, what is the expected return of your portfolio?

Solution Summary

Solution describes the steps to calculate expected return of the given portfolio by using three factor model.

Solution Preview

We are given RF=2%, F1=5.3%, F2=3.9%, B3=4.2%

For Stock A,
B1=1.45, B2=0.80, B3=0.05, ...

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• BEng (Hons) , Birla Institute of Technology and Science, India
• MSc (Hons) , Birla Institute of Technology and Science, India
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