Question

Consider the multifactor model APT with three factors. Portfolio A has a beta of 0.8 on factor 1, a beta of 1.1 on factor 2, and a beta of 1.25 on factor 3. The risk premiums on the factor 1, factor 2, and factor 3 are 3%, 5% and 2%, respectively. The risk-free rate of return is 3%. The expected return on portfolio A is __________if no arbitrage opportunities exist. A) 13.5% B) 13.4% C) 16.5% D) 23.0% E)none of the above

Answer 1

Answer:

B) 13.4%

Explanation:

In this question, we apply the Capital Asset Pricing Model (CAPM) formula which is shown below

Expected rate of return = Risk-free rate of return + Beta × (Market rate of return - Risk-free rate of return)

The (Market rate of return - Risk-free rate of return)  is also known as market risk premium

So, the expected return on portfolio A would be

= Risk free-rate of return + (Beta of factor 1 × risk premium + Beta of factor 2 × risk premium + Beta of factor 2 × risk premium)

= 3% + (0.8 × 3% + 1.1 × 5% + 1.25 × 2%)

= 3% + 2.4% + 5.5% + 2.5%

= 13.40%