Question #17
Reading: Reading 36 Using Multifactor Models
PDF File: Reading 36 Using Multifactor Models.pdf
Page: 8
Status: Correct
Correct Answer: A
Question
Assume you are attempting to estimate the equilibrium expected return for a portfolio using a two-factor arbitrage pricing theory (APT) model. Assume that you have estimated the risk premium for factor 1 to be 0.02, and the risk premium for factor 2 to be 0.03. The sensitivity of the portfolio to factor 1 is –1.2 and the portfolios sensitivity to factor 2 is 0.80. Given a risk free rate equal to 0.03, what is the expected return for the asset?
Answer Choices:
A. 5.0%
B. 2.4%
C. 3.0%
Explanation
The general form of the two-factor APT model is: E(RPort) = RF = λ1β1 + λ2β2, where the λ's
are the factor risk premiums and the β's are the portfolio's factor sensitivities. Substituting
the appropriate values, we have:
RPort = 0.03 + 0.02(−1.2) + 0.03(0.80) = 3.0%