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    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?

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    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, ...

    Solution Summary

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