1.Your forecasting model projects an expected return of 10% for Stock A and an e
ID: 2699917 • Letter: 1
Question
1.Your forecasting model projects an expected return of 10% for Stock A and an expected return of 17% for Stock B. Using your forecasted expected returns, what is your best estimate of the alpha of your portfolio when using CAPM to determine a fair level of expected return?
2. A different analyst uses a two-factor APT model to evaluate expected returns and risk. The risk premiums on the factor 1 and factor 2 portfolios are 5% and 4%, respectively, while the risk-free rate of return remains at 3%. According to this APT analyst, your portfolio formed in question 2 has a beta on factor 1 of 1.7 and a beta on factor 2 of 2.5. According to APT, what is the expected return on your portfolio if no arbitrage opportunities exist?
3. Now assume that your forecasting model of question 1 accurately projects the expected return of Stocks A and B and therefore your portfolio, and that the APT model of question 2 describes the fair rate of return for your portfolio. Do any arbitrage opportunities exist?
Explanation / Answer
a) Ra = 3 + 1.25*( 9 - 3) = 10.5%...................... Rb = 3 + 1.95 * ( 9 - 3) = 14.7 %................ return of portfolio = 0.6 * 10.5 + 0.4* 14.7 = 12.18% ............................. alpha for a = 12.18 - 10.5 = 1.68............ alpha for b = 12.18 - 14.7 = -2.52....... B) R1 = 3 + 5*1.7 = 11.5................................. R2 = 3 + 4*2.5 = 13.................................... Rp = (11.5 + 13)/2 = 12.25................... C) since return by the two methods are not the same so we but the stocky by APT method and sale by forcast.So arbitrage opportunity is present
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