Question: Assume that security returns are generated by a factor model in which two factors are pervasive. The sensitivities of two securities and of the riskfree asset to each of the two factors are shown below, along with the expected return on each security.
Security bi1 bi2 Expected Return
A 0.5 0.8 16.2%
B 1.5 1.4 21.6
Rf 0.0 0.0 10.0
a) If Dots Miller has $100 to invest and sells $50 of security B and purchases $150 of security A, what is the sensitivity of Dot’s portfolio of the two factors? Ignore margin requirements.
b) If Dots now borrows $100 at the rskfree rate and invests the proceeds of the loan along with the original $100 in securities A and B in the same proportions as described in part (a), What is the sensitivity of this portfolio to the two factors?
c) What is the expected return of the portfolio created in part (b) ?
d) What is the expected return premium of factor 2?