You want to investigate whether a convertible-bond arbitrage strategy is earning alpha, i.e. abnormal risk-adjusted returns. You regress the time series of monthly portfolio returns on the following factors: RPt = alpha + beta1 RMt +beta2 CRt + beta3 IRt + epsilont. Where RPt is the excess return of your portfolio, RMt is the market risk premium; CRt is a credit risk factor, and IRt is an interest rate risk factor. You obtain the following estimates: Coefficient Estimate t-statistic alpha 0.202 2.67 beta1 1.300 3.22 beta2 -0.114 -3.12 beta3 -0.100 -0.97 You then add a market volatility factor (MV) to the regression. RPt = alpha + beta1 RMt +beta2 CRt + beta3 IRt + beta4 MVt + epsilont. You obtain the following estimates: Coefficient Estimate t-statistic alpha -0.001 -1.07 beta1 0.895 2.67 beta2 -0.167 -1.13 beta3 -0.190 -1.31 beta4 0.405 2.96 a. [5] Interpret the coefficient estimates in the first and second regressions. b. [5] What are good proxies for credit risk, interest rate risk and market volatility? c. [3] Does your portfolio earn alpha? Explain. d. [5] Which risks is the manager hedging and which not? Explain. e. [5] In which securities and in which proportion would you trade to passively replicate the managers strategy so that you get the same performance without the alpha?

Question 4 (23 points) You want to investigate whether a convertible-bond arbitrage strategy is eaming alpha, i.e. abnormal risk-adjusted returns. You regress the time series of monthly portfolio returns on the following factors: Rpt = alpha + betai Rme +beta2 CRt + betas IR + epsilont. Where Rpt is the excess return of your portfolio, Rot is the market risk premium; CR is a credit risk factor, and IR is an interest rate risk factor. You obtain the following estimates: Coefficient alpha beta beta2 betas Estimate 0.202 1.300 -0.114 -0.100 t-statistic 2.67 3.22 -3.12 -0.97 You then add a market volatility factor (MV) to the regression. Rpt = alpha + beta: Ram+beta2 CR + beta3 IR + beta: MV + epsilon You obtain the following estimates: Coefficient alpha beta beta2 betag beta Estimate -0.001 0.895 -0.167 -0.190 0.405 t-statistic -1.07 2.67 -1.13 -1.31 2.96 a. (5) Interpret the coefficient estimates in the first and second regressions. b. [5] What are good proxies for credit risk, interest rate risk and market volatility? C. (3) Does your portfolio earn alpha? Explain. d. (5) Which risks is the manager hedging and which not? Explain. e. [5] In which securities and in which proportion would you trade to passively replicate the manager's strategy so that you get the same performance without the alpha? Question 4 (23 points) You want to investigate whether a convertible-bond arbitrage strategy is eaming alpha, i.e. abnormal risk-adjusted returns. You regress the time series of monthly portfolio returns on the following factors: Rpt = alpha + betai Rme +beta2 CRt + betas IR + epsilont. Where Rpt is the excess return of your portfolio, Rot is the market risk premium; CR is a credit risk factor, and IR is an interest rate risk factor. You obtain the following estimates: Coefficient alpha beta beta2 betas Estimate 0.202 1.300 -0.114 -0.100 t-statistic 2.67 3.22 -3.12 -0.97 You then add a market volatility factor (MV) to the regression. Rpt = alpha + beta: Ram+beta2 CR + beta3 IR + beta: MV + epsilon You obtain the following estimates: Coefficient alpha beta beta2 betag beta Estimate -0.001 0.895 -0.167 -0.190 0.405 t-statistic -1.07 2.67 -1.13 -1.31 2.96 a. (5) Interpret the coefficient estimates in the first and second regressions. b. [5] What are good proxies for credit risk, interest rate risk and market volatility? C. (3) Does your portfolio earn alpha? Explain. d. (5) Which risks is the manager hedging and which not? Explain. e. [5] In which securities and in which proportion would you trade to passively replicate the manager's strategy so that you get the same performance without the alpha