Question

Consider a multifactor model with two factors. A well-diversified portfolio (Portfolio P) has a beta of 0.75 on factor 1 and a beta of 1.25 on factor 2. The risk premiums on the factor 1 and factor 2 are 1% and 7%, respectively. The risk-free rate of return is 7%. What is the expected return on portfolio P, according to a two-factor model

Answer 1

Answer: 16.5%

Explanation:

Expected Return on portfolio P will be calculated as:

= Rf + (Beta1 × F1) + (Beta2 × F2)

where,

Rf = Risk Free rate

F1 = risk premium on Factor1

F2 = risk premium on Factor2

Expected Return will now be:

= 7% + (0.75 × 1%) + (1.25 × 7%)

= 7% + 0.75% + 8.75%

= 16.5%

The expected return on portfolio P, according to a two-factor model will be 16.5%.

Answer 2

Answer:

16.5%

Explanation:

A multi-factor model can be used to explain either an individual security or a portfolio of securities. It does so by comparing two or more factors to analyze relationships between variables and the resulting performance.

DATA

Risk Free rate  = Rf = 7%

risk premium on Factor1  = F1 =  1%

Beta (Factor 1) = 1.25

risk premium on Factor2  = F2 = 7%

Beta (Factor 1) = 2

Expected Return = Rf + (Beta1 x F1) + (Beta2 * F2)

Expected Return = 7% + (0.75 x 1%) + (1.25 x 7%)

Expected Return = 0.07 + 0.0075 + 0.0875

Expected Return = 0.165 or  16.5%