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SOLUTIONS TO THE PROBLEM SET FOR MODULE ON FACTOR AND INDEX MODELS
47. The weights of Ms. Z's portfolio are 30% on stock A, 40% on B and the rest on C. The
betas of these stocks are 1.43, .78, and 1.10, respectively. The standard deviations of
the non-systematic risks of these stocks are .22, .10, and .16, respectively. The standard
deviation of the market's return is .15. What is the beta of Ms. Z's portfolio? What is
the variance of her portfolio's total, systematic and non-systematic risk?
In the CAPM world, the period by period returns on portfolios and individual stocks are given by
the following equation:
~ ~
R pf , t =r f + β pf ( R M , t −r f )+~ε pf , t
where ~ε pf ,t summarizes fluctuations in the returns due to the events, which are unique to the
portfolio (or stock) in question. Take variance of the above equation and receive:
σ 2pf =β 2pf σ 2M + σ 2ε
where σ 2pf is the total risk of the portfolio, β 2pf σ 2M is its systematic risk and σ 2ε is its unsystematic
risk (systematic and unique risks are uncorrelated by definition and therefore there is no
covariance term in the variance formula)
There are no covariance terms in the above expression because unique risks of individual stocks
in the portfolio are uncorrelated.
Ri=α i + β i R M +ε i
where Ri is the excess return for security i -- ( r i −r f ) and Rm is the market’s excess return
( r m −r f ). Suppose that there are three securities A, B, and C characterized by the following
data:
(b) Now assume that there are an infinite number of assets with return characteristics
identical to those of A, B, and C respectively. If one forms a well-diversified portfolio of
type A securities, what will be the mean and variance of the portfolio’s excess above rf
returns? What about portfolios composed only of type B or C stocks?
(c) Is there an arbitrage opportunity in this market? What is it? Analyze the opportunity
graphically.
σ i2=β 2i σ 2M +σ 2ε i
(b) In the portfolio of many securities, the unique risks all are diversified away to zero via
the mechanism of pooling.
σ 2 ( ε p ) → 0 as N → ∞
For the portfolio of stocks type A, σ 2p=0.001, for the portfolio of stocks type B,
σ 2p=0.0016, and for the portfolio of stocks type C, σ 2p=0.0023.
(c) The issue is whether these stocks lie on the SML (their unique risks are irrelevant as they
are held as assumed as members of well-diversified portfolios).
E[r]
.8 1 1.2 Beta
Yes, they all lie on the same line there is no evidence of an arbitrage opportunity.
We can verify that by constructing a portfolio of two securities with the same factor sensitivity
(systematic risk) as the third security. If the portfolio has a different return, there is an arbitrage
opportunity. If the portfolio pays the same return as the third security, there is no arbitrage.
For example, let us construct the portfolio of A and C with the same factor sensitivity as that of
security B:
w A β A +¿ ¿
Or
0.8 w A +1.2(1−w¿¿ A)=1 ¿
w A=0.5
This is exactly the expected return on the security B, so there is no arbitrage opportunity.
80. Mr. X owns a portfolio with the following characteristics (assume that returns are
generated by a single-factor model):
EXPECTED
SECURITY SENSITIVITY PROPORTION
RETURN
A 2.0 .20 20%
B 3.5 .40 10
C 0.5 .40 5
Mr. X decides to create an arbitrage portfolio with the holdings of security A being .20.
(a) What must be the weights of the other two securities in Mr. X’s arbitrage
portfolio?
(c) If everyone follows Mr. X’s buy and sell decisions, what will be the effects on the
prices of the three securities?
w A + wB + wC =0
w A b1 A + wB b 1 B +w C b 1C =0
(c) This suggests Mr. X should buy A and short B and C. If everybody will follow the same
strategy the return on A will be reduced and returns on B and C will be increased until the
opportunity is gone.
81. Based on a single-factor model, assume that the risk-free rate is 6% and the expected
return on a portfolio with unit sensitivity to the factor is 8.5%. Consider a portfolio of
two securities with the following characteristics:
SECURITY PROPORTION
SENSITIVITY
A 4.0 .30
B 2.6 .70
Portfolio with unit sensitivity to the factor has an expected return of 8.5% and the risk free rate is
6%, therefore
0 . 085=0 . 06+λ 1×1
λ1 =0 . 025
According to APT lambdas are constants and are the same for all securities. Expected returns on
securities A and B are
E [ r A ]=0.06+0.025 × 4=0.16
E [ r A ] =0 .06+ 0 .025×4=0. 16
E [ r B ] =0 .06 +0 .025×2 .6=0 . 125
E [ r pf ] =w A ×E [ r A ]+w B×E [ r B ]
E [ r pf ] =0 .3×0 .16 +0 .7×0 . 125=0 . 1355
83. Consider a market where two factors are sufficient to describe the returns on
common stock. The following table gives the sensitivities of the stocks of ABC inc.
and PQR inc. to the two factors, as well as the expected returns.
Security Bil Bi2 E[Ri]
(i) Consider a portfolio, C, made up by selling short $.50 of security PQR and
purchasing $1.50 of ABC with the proceeded and with $1.00 of your own money
in portfolio C. How sensitive will this portfolio be to each of the two factors?
(ii) Consider a portfolio, D, made up by borrowing $1.00 at the risk free rate and
investing it with $1.00 0f your own money in portfolio C. How sensitive will this
portfolio be to each of the factors?
(iii) What combination of securities ABC, PQR and the riskless security will move on
a one-to-one basis with factor 1 and be insensitive to factor 2?
(iv) You have discovered another portfolio P with the following characteristics:
P 1 0 .08
β D 1=w C β C 1=2∗0=0
β D 2=w C β C 2=2∗0.5=1
(iii) The factor sensitivities of portfolio P should satisfy the following equations:
w A + wB + wrf =1
We can solve these three equations for three weights. The result is:
w A=−2.8 w B=1.6 w rf =2.2
(iv) Although portfolio P* has the same factor sensitivities as the portfolio described in
part (ii), its expected return is different.
Thus, in every state the return on our portfolio in (ii) will exceed the return on P* by 3.2%.
1,000,000
Short P* in the amount =31,250,000
0.032
1,000,000
Long P in the amount =31,250,000
0.032
Note: we are ignoring unique risks and assuming, in effect, that P* and P are well diversified.
Strictly speaking, this is a payoff in one period. If we wanted a payoff today, the issue would
be to solve the problem as follows:
Let
x = amount long of portfolio P
y = amount short of portfolio P*
In the second equation, since factors are equivalent they add up to zero. Solving, we obtain:
x=33,750,000∧ y=34,750,000