Suppose you use the following two-factor APT to make investment decisions. The f

Question

Suppose you use the following two-factor APT to make investment decisions. The first factor is the unexpected increase in the growth rate of industrial production, F_IP, and the second factor is the unexpected decline in interest rate, F_IR. Assume that the two factors are uncorrelated. Stated formally, according to your model, expected return for any well-diversified portfolio is given by E(r_p) = lambda_0 + beta_P, IP lambda_IP + beta_P, IR lambda_IR There are two well-diversified portfolios A and D with the following factor sensitivities: The expected returns on A and D are 9% and 8%, respectively. Suppose that A and D are priced consistently with your model. All investors can lend or borrow freely at the risk-free rate of 4%. You discover a well-diversified portfolios X whose return is generated according to the following equation: r_x - 12 + 1.5F_IP + 0.5 F_IR Show that X is not priced consistently with your model. Show how you can profit from this situation by using A, B. X, and the risk-free asset.

Explanation / Answer

Suppose you use the following two-factor APT to make investment decisions. The f

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.