Question #21
Reading: Reading 36 Using Multifactor Models
PDF File: Reading 36 Using Multifactor Models.pdf
Page: 9
Status: Incorrect
Correct Answer: B
Your Answer: C
Question
Portfolios A and B have an expected return of 4.4% and 5.3% respectively. Assume that a one-factor APT model is appropriate and the factor sensitivities of portfolios A and B are 0.8 and 1.1 respectively. The risk-free rate and factor risk premium are closest to: Risk Free Rate Factor Risk Premium
Answer Choices:
A. 2.50% 3.00%
B. 2.00% 3.00%
C. 3.00% 2.00%
Explanation
Expected return = risk free rate + factor sensitivity x risk premium
For portfolio A: 0.044 = Rf + 0.8λ Hence Rf = 0.044 – 0.8λ
Substituting Rf = (0.04 – 0.8λ) for portfolio B, 0.053 = (0.044 – 0.8λ) + 1.1λ
λ = 0.03 or 3% and Rf = 2%.