Sam Porter is evaluating three portfolios based on Carhart Model.

The following table provides the factor exposures of each of

Risk Factor
Portfolio RMRF SMB HML WML
Eridanus 1 0 0 0
Scorpius 0 1 0 0
Lyra 1.2 0 0.2 0.8

Which strategy would be most appropriate if the manager expects that:

1)RMRF will be highrer than expected
2)Large caps will outperform small cap

Solution:
1) The manager would go long on the eridanus portfolio as it is constructed to have exposure only to RMRF Factor

2) Short Scorpius as it is constructed to be pure bet on SMB

Compute the E(Rp) from the following information using the Carhart Model
What would be your answer if (a) Rf =7.2%, (b) WML = 3.6% (c) Beta 3 and 4 were 1.0
Rf 0.068
Beta 1 (RMRF) 1.2
Beta 2 (SMB) 0.9
Beta 3 (HML) 0.7
Beta 4 (WML) 1.3
RMRF factor 4%
R_SMB 8%
R_HML 3%
R_WML 1.50%

ERp 22.85%
RF = 7.2% 23.2500%
WML = 3.6 25.5800%
Beta 3,4 23.300%
 or exposures of each of these portfolios to the four carhart factors

Carhart Model

only to RMRF Factor

part A
Suppose we derive following factor values from market data:
Rm-Rf 4.80%
Rsmall-Rbig 2.40%
Rhbm-Rlbm 1.60%
Rf 3.40% r = Rf + Beta*(Rm-Rf)
CAPM Beta 1.30
Beta(mkt) 1.20 CAPM 9.64%
Beta(smb) 0.40 FF 9.80%
Beta(hml) -0.20

What will be required return using CAPM and Fama-French Model

Solution
CAPM 9.64%

Fama-French 9.80%

Suppose we derive following factor values from market data:

Rm-Rf 9.60%
Rsmall-Rbig 3.40%
Rhbm-Rlbm 2.50% FF 17.9100%
Rf 6.25% CAPM 10.090%
CAPM Beta 0.40
Beta(mkt) 1.00
Beta(smb) 0.90
Beta(hml) -0.40

What will be required return using CAPM and Fama-French Model

Solution
CAPM 10.09%

Fama-French 17.91%
Fama-French
The estimated factor sensitivity of TEC to the five macro economic factors are given in th

Factor Factor Risk premium

sensitivity (%)

Confidence risk 0.25 2.59

Time horizon risk 0.3 -0.66
Inflation risk -0.45 -4.32
Business cycle risk 1.6 1.49
Market timing risk 0.8 3.61
Use APT model to calculate the required rate of return for TEC. The treasury bill rate is 4.1%.

SOLUTION
Required Return (excess return) 7.6655 %
Required Return 11.7655 %

Ri = αi + βiGDP *(GDP factor risk premium) + βiIR *(Int. factor risk premium)+..+ ei
OR

ri-rf = βiGDP *(GDP factor risk premium) + βiIR *(Int. factor risk premium)+..+ ei
Where, αi = Intercept or RF rate
tors are given in the table below

APT PPT Slide then sums

y bill rate is 4.1%.

mium)+..+ ei

um)+..+ ei
Assume that only two macro economic factors, F1 & F2, impact security returns. Investments A
Investment b1 b2
A 1.75 0.25
B -1 2
C 2 1
We are given the expected risk premium is 4% on factor 1 and 8% on factor 2. According to the APT,
What is the risk premium on each of the three stocks?
Suppose we buy Rs. 2,00,000 of A and Rs. 50,000 of B and sell Rs. 1,50,000 of C.
What is the sensitivity of this portfolio to each of the two factors? What is the expected risk premium on portfolio

Investment b1 b2 Risk Premium on

stock InvestmenWeights Beta1
A 1.75 0.25 9% 200000 2 3.5
B -1 2 12% 50000 0.5 -0.5
C 2 1 16% -150000 -1.5 -3
Risk Premium of
Factor (not
stock) 4% 8% 1 0

For A = β1*risk premium of factor 1 + β2*risk premium of factor 2 9.00%

Similarly for B and C

Sensitivity to each of the 2 factors Sensitivtiy of the porttoflio is the Weighted

Sensitivity of Portfolio to factor 1 0 i.e. Wa*Ba+Wb*Bb+Wc*Bc for a Portfolio
Sensitivity of Portfolio to factor 2 0
Since the sensitivity of the portfolio to the 2 factors is 0, it is a Risk free portfolio, i.e. a 0 beta portfolio

Author:
Expected Risk premium of portoflio is : 0.00 Risk premium*Weights
ty returns. Investments A, B and C have the following sensitivities to these two factors:

APT

premium on portfolio

Beta2
0.5
1
-1.5

of the porttoflio is the Weighted Average BETA value

+Wb*Bb+Wc*Bc for a Portfolio
Mr. X owns a portfolio with the following characteristics:
Security A Security B Risk free
Investment
(beta) (beta) security
Factor 1 0.5 1.5 0
Factor 2 0.8 1.4 0
Expected
15% 20% 10%
return
It is assumed that the security’s returns are generated by two factor model:
(a) In what combination one should invest in A and B, that the overall portfolio is in
Author: Author:
(b) In
usewhat
solver, combination
non-negative one shoulduse
invest in A, B and risk free security so that the o
Goal Seek:
tick amrk remove Set cell E13 to 0, i.e.
factor 2 is insensitive, by
changing Wa
233,333 -133,333 100,000

2.33 -1.33 1.00

Security A Security B Risk free

Investment (beta) (beta) security
Factor 1 0.5 1.5 0
Factor 2 0.8 1.4 0 0
Expected 15% 20% 10%
return

Weights 2.33 -1.33

Rtn/Unit of
Risk 18.75% 14.29%

L S

Security A Security B Risk free

Investment
(beta) (beta) security
Factor 1 0.5 1.5 0 1.000
Factor 2 0.8 1.4 0 -0.000
Expected 15% 20% 10%
return
Weights -2.80 1.60 2.20

1.00
 APT

the overall portfolio is insensitive to changes in factor 2?

free security so that the overall portfolio is insensitive to changes in factor 2 and has sensitivity of 1 to fa
desired factor sensitivites using Solver
has sensitivity of 1 to factor 1?
Mr. X owns a portfolio with the following characteristics:
Risk free
Investment Security A Security B
security
Factor 1 0.8 1.5 0
sensitivity
Factor 2 0.6 1.2 0
sensitivity
Expected
15% 20% 10%
return

It is assumed that the security returns are generated by two factor model:
(i) If Mr. X has Rs. 1,00,000 to invest and sells short Rs. 50,000 of security B and p
what is the sensitivity of Mr. X’s portfolio to each of the two factors?
(ii) If Mr. X borrow Rs. 1,00,000 at the risk free rate and invests the amount he bor
the original amount Rs. 1,00,000 in security A and B in the same proportion as
what is the sensitivity of the portfolio to the two factors?

Risk free
Investment Security A Security B security

Factor 1 0.8 1.5 0

sensitivity 0.45
Factor 2 0.6 1.2 0
sensitivity 0.30
Expected 15% 20% 10%
return

150000 -50000 100000

1.5 -0.5 1
 Risk free
Investment Security A Security B security

Factor 1 0.8 1.5 0

sensitivity 0.90
Factor 2 0.6 1.2 0
sensitivity 0.60
Expected
15% 20% 10%
return

300000 -100000 -100000 100000

3 -1 -1 1
50,000 of security B and purchases Rs. 1,50,000 of security A
he two factors?
nvests the amount he borrows along with
n the same proportion as described in part (i),
Suppose the returns are described by two factor model
Assume existence of diversified portfolios shown in the following table
Security ER (%) Beta1 Beta2
A 15 1 0.6
B 14 0.5 1
C 10 0.3 0.2
Now Suppose portfolio E exists with an expected return of 15%, a beta1 of 0.6 and beta 2 of 0.6
What happens when you form a combination of portfolios A,B and C (call it Portfolio D) which h
Find the expected return on Portfolio D
Do you have an Arbitrage startegy?
What is the riskless gain? What will happen with the expected return of portfolio E

Sec A Sec B Sec C

Exp Rtn 15% 14% 10% Beta 1

Weights 0.333333 0.333333 0.333333 Weights

Exp Rtn (D) 13% Weighted Factor Sensitivity

Portfolio E 15%

Long Portfolio E 15%

Short Portfolio D 13%

Arbitrage Gain 2%
 APT

1 of 0.6 and beta 2 of 0.6

all it Portfolio D) which has equal investment of each?

of portfolio E

Sec A Sec B Sec C Sec A Sec B Sec C

1.00 0.50 0.30 Beta 1 0.60 1.00 0.20

0.333333 0.333333 0.33333333 Weights 0.333333 0.333333 0.333333

Weighted Factor Sensitivity 0.6 Weighted Factor Sensitivity 0.6

0.6 0.6
Mr. Tamarind intends to invest in equity shares of a company the value of which depends upon
Expected Actual
Factor Beta
value in% value in % Risk Prem
GNP 1.2 7.7 7.7 -
Inflation 1.75 5.5 7 1.50

Interest rate 1.3 7.75 9

1.25

Stock market
index 1.7 10 12
2.00
Industrial 1 7 7.5
production 0.50
If the risk free rate of interest be 9.25%, how much is the return of the share under Arbitrage P

Shock
Factor Beta Expected Actual (risk beta*Risk
value in% value in % Premium
premium)

GNP 1.2 7.7 7.7 0 0

Inflation 1.75 5.5 7 1.5 2.625

Interest rate 1.3 7.75 9

1.25 1.625

Stock market 1.7 10 12

index
2 3.4
Industrial 1 7 7.5
production 0.5 0.5

Total Risk Premium 8.15

Risk Free Rate 9.25

Total return 17.4

e of which depends upon various parameters as mentioned below:

WFS 8.15

Rf 9.25 17.4

share under Arbitrage Pricing Theory?

APT