Suppose that the rate of return on risky assets is given by the following single factor model: ri = E(r;) + BiF + e; where F is the factor affecting returns on all securities and e; is a firm-specific dis- turbance. The risk-free rate is 4% and borrowing at this rate is possible. Two well- diversified portfolios P and Q are found to have the following expected returns and betas: E(rp) = 12% E(rq) = 15% Bp = 0.8 BQ = 1 (a) Is the data consistent or inconsistent with Arbitrage Pricing Theory? Explain. (b) Construct a zero investment portfolio that yields a sure profit and does not involve borrowing. What are the weights of P and Q in your portfolio? Are you investing in bills?

Suppose that the rate of return on risky assets is given by the following single factor model: ri = E(r;) + BiF + e; where F is the factor affecting returns on all securities and e; is a firm-specific dis- turbance. The risk-free rate is 4% and borrowing at this rate is possible. Two well- diversified portfolios P and Q are found to have the following expected returns and betas: E(rp) = 12% E(rq) = 15% Bp = 0.8 BQ = 1 (a) Is the data consistent or inconsistent with Arbitrage Pricing Theory? Explain. (b) Construct a zero investment portfolio that yields a sure profit and does not involve borrowing. What are the weights of P and Q in your portfolio? Are you investing in bills?

FINANCIAL ACCOUNTING

10th Edition

ISBN:9781259964947

Author:Libby

Publisher:Libby

Chapter1: Financial Statements And Business Decisions

Section: Chapter Questions

Problem 1Q

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Concept explainers

Treasury Market

On-the-run securities are the most recently issued securities in the market depth and are therefore traded at some premium. The off-the-run securities are the ones issued just before the most recent ones. The on-the-run securities have a lower yield to the investor than the off-the-run securities.

Question

Suppose that the rate of return on risky assets is given by the following single factor
model:
ri = E(r;) + BiF + e;
where F is the factor affecting returns on all securities and e; is a firm-specific dis-
turbance. The risk-free rate is 4% and borrowing at this rate is possible. Two well-
diversified portfolios P and Q are found to have the following expected returns and
betas:
Bp = 0.8
Bo = 1
E(гр) — 12%
E(rq) = 15%
(a) Is the data consistent or inconsistent with Arbitrage Pricing Theory? Explain.
(b) Construct a zero investment portfolio that yields a sure profit and does not involve
borrowing. What are the weights of P and Q in your portfolio? Are you investing
in bills?

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