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Arbitrage Pricing Theory Exercise

This document provides an in-class exercise on arbitrage pricing theory that involves a two-factor model for the returns of three stocks. It asks the reader to: 1) Calculate the variances, covariances, and correlations between the returns of the three stocks. 2) Determine the expected returns of each of the three stocks. 3) Write out the factor betas, factor equations, and expected returns for two portfolios - one consisting of long and short positions in the three stocks, and another adding a short position of one of the stocks to the first portfolio.

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Shin Yuen
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11 views3 pages

Arbitrage Pricing Theory Exercise

This document provides an in-class exercise on arbitrage pricing theory that involves a two-factor model for the returns of three stocks. It asks the reader to: 1) Calculate the variances, covariances, and correlations between the returns of the three stocks. 2) Determine the expected returns of each of the three stocks. 3) Write out the factor betas, factor equations, and expected returns for two portfolios - one consisting of long and short positions in the three stocks, and another adding a short position of one of the stocks to the first portfolio.

Uploaded by

Shin Yuen
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

In-Class

Exercise 7 Arbitrage Pricing Theory


Question 1 Consider the following two-factor model for the returns of three stocks. Assume that the factors and epsilons have means of zero. Also, assume the factors have variance of 0.01 and are uncorrelated with each other.

Assume:

a) What are the variances of the returns of the three stocks, as well as the covariance and correlation between them? b) What are the expected returns of the three stocks? c) Write out the factor betas, factor equations, and expected returns of the following portfolios: i. A portfolio of the three stocks in above with $20,000 invested in stock A, -$20,000 invested in stock B, and $10,000 invested in stock C. ii. A portfolio consisting of the portfolio formed in part (i) and a $3,000 short position in stock C. Question 1 Solution a) What are the variances of the returns of the three stocks, as well as the covariance and correlation between them?

b) What are the expected returns of the three stocks?

c) Write out the factor betas, factor equations, and expected returns of the following portfolios: i. A portfolio of the three stocks in above with $20,000 invested in stock A, -$20,000 invested in stock B, and $10,000 invested in stock C.

ii. A portfolio consisting of the portfolio formed in part (i) and a $3,000 short position in stock C.

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