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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 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, ...

Solution provided by:
Lokesh Jain, MSc
Education
  • BEng (Hons) , Birla Institute of Technology and Science, India
  • MSc (Hons) , Birla Institute of Technology and Science, India
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