Consider the following simplified APT model: Factor Expected Risk Premium Market 6.4% Interest Rate -0.6% Yield Spread 5.1% Factor Risk Exposures Market Interest Rate Yield Spread Stock Stock (b1) (b2) (b3) P 1.0 -2.0 -0.2 P2 1.2 0 0.3 P3 0.3 0.5 1.0 a) Calculate the expected return for the above stocks. Assume risk free rate is 5%. Consider a portfolio with equal investments in stocks P, P2 , and P3 b) What are the factor risk exposures for the portfolio? c) What is the portfolio’s expected return?
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
Consider the following simplified APT model:
Factor Expected Risk Premium
Market 6.4%
Interest Rate -0.6%
Yield Spread 5.1%
Factor Risk Exposures
Market Interest Rate Yield Spread Stock Stock (b1) (b2) (b3)
P 1.0 -2.0 -0.2
P2 1.2 0 0.3
P3 0.3 0.5 1.0
a) Calculate the expected return for the above stocks. Assume risk free rate is 5%. Consider a portfolio with equal investments in stocks P, P2 , and P3 b) What are the factor risk exposures for the portfolio?
c) What is the portfolio’s expected return?
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