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3. (Bonus) (4 points) Consider a market where two factors are sufficient to describe the returns on common stocks. For an asset i, the asset's

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3. (Bonus) (4 points) Consider a market where two factors are sufficient to describe the returns on common stocks. For an asset i, the asset's expected return is given by E(n)=rr+i11+i22, where 1 and 2 are the factor premiums (expected return of the factors in excess of the risk-free rate). Both factors are independent. The following table gives the sensitivities of the stocks ABC and PQR to the two factors, as well as the expected returns of each stock (Hint: Portfolio betas are weighted averages of individual stock betas. This is also true for betas for each factor): (a) (1 point) Consider a portfolio, C, made up by selling short $0.50 of security PQR and purchasing $1.5 of ABC. How sensitive will this portfolio be to each of the two factors? (b) (1 point) Consider a portfolio, D, made up by borrowing $1.00 at the risk-free rate and investing $1.0 portfolio C. How sensitive will this portfolio be to each of the factors? (c) (2 points) What combination of securities ABC,PQR, and the riskless security will move on a one-t one basis with factor 1 and be insensitive to factor 2 ? 3. (Bonus) (4 points) Consider a market where two factors are sufficient to describe the returns on common stocks. For an asset i, the asset's expected return is given by E(ri)=+i11+22, where 1 and 2 are the factor premiums (expected return of the factors in excess of the risk-free rate). Both factors are independent. The following table gives the sensitivities of the stocks ABC and PQR to the two factors, as well as the expected returns of each stock (Hint: Portfolio betas are weighted averages of individual stock betas. This is also true for betas for each factor): (a) (1 point) Consider a portfolio, C, made up by selling short 50.50 of security PQR and purchasing $1.50 of ABC. How sensitive will this portfolio be to each of the two factors? (b) (1 point) Consider a portfolio, D, made up by borrowing $1.00 at the risk-free rate and investing $1.00 in portfolio C. How sensitive will this portfolio be to each of the factors? (c) (2 points) What combination of securities ABC,PQR, and the riskless security will move on a one-toone basis with factor 1 and be insensitive to factor 2

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