Exercise

Yields of financial assets can be explained by a process of two factors:

𝑅𝑖 = 𝑎𝑖 + 𝑏𝑖1𝐹1 + 𝑏𝑖2𝐹2 + ε𝑖

X, Y and Z are three portfolios well diversified, with some characteristics summarized in the
table below:

Portfolio p 𝐸(𝑅𝑝) 𝑏𝑃1 𝑏𝑝2

X 8% O,3 0,6
Y 10,5% 0,5 1
Z 11,125% 1 0,5

1. Give the Arbitrage Pricing Theory equation? ()

2. A portfolio (A) admit these characteristics :
( )
𝐸 𝑅𝐴 = 12, 25%, 𝑏𝐴1 = 0, 7, 𝑏𝐴2 = 0, 65
a. How can we construct the portfolio (A) using (X),(Y) and (Z)? ()
b. Give the arbitrage process and calculate the arbitrage gain?
( )
3. A portfolio (B) admit these characteristics: 𝐸 𝑅𝐵 = 8, 55%, 𝑏𝐴1 = 0, 6, 𝑏𝐴2 = 0, 7.
Give the arbitrage process and calculate de arbitrage gain. (5 points)
4. If the CAPM and the APT give the same expected return, and the market premium
equal to 5%. Calculate the Betas of the portfolios X, Y and Z. (2points)

Correction:
1) The APT equation:

( )
𝐸 𝑅𝑝 = λ0 + λ1𝑏𝑝1+λ2𝑏𝑝2

𝑋: 8% = λ0 + 0, 3λ1 + 0, 6λ2 𝑌: 10, 5% = λ0 + 0, 5λ1 + λ2 𝑍: 11, 25% = λ0 + λ1 + 0, 5λ2

𝑌 − 𝑋 = 2, 5% = 0, 2λ1 + 0, 4λ2 𝑍 − 𝑌 = 0, 625 = 0, 5λ1 − 0, 5λ2

( ) ( )
𝑌 − 𝑋 = 2, 5% * 5 = 0, 2λ1 + 0, 4λ2 * 5 (𝐼) 𝑍 − 𝑌 = 0, 625 * 2 = 0, 5λ1 − 0, 5λ2 * 2 (𝐼𝐼)

(𝐼): 12, 5% = λ1 + 2λ2 → λ1 = 12, 5% − 2λ2 (𝐼𝐼): 1, 25% = λ1 − λ2

( )
(𝐼)𝑖𝑛 (𝐼𝐼): 1, 25% = 12, 5% − 2λ2 − λ2→12, 5% − 3λ2: →3λ2 = 12, 5% − 1, 25% = 11, 25%
 11,25%
→ λ2 = 3
= 3, 75%

λ1 = 12, 5% − 2λ2 ↔ λ1 = 12, 5% − 2 * 3, 75 = 5%

λ0 = 4, 25%

λ0 = 4, 25% = 𝑅𝑓 λ1 = 5% λ2 = 3, 75%

So :
The APT equation is :
( )
𝐸 𝑅𝑖 = 4, 25% + 5%𝑏𝑖1 + 3, 75%𝑏𝑖2

( )
2) 𝐸 𝑅𝐴 = 12, 25% : 𝑜𝑏𝑠𝑒𝑟𝑣𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛, 𝑏𝐴1 = 0, 7, 𝑏𝐴2 = 0, 65

0, 3𝑤𝑥 + 0, 5𝑤𝑦 + 𝑤𝑧 = 0, 7 𝑠𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑖𝑡𝑦 𝐹1 0, 6𝑤𝑥 + 𝑤𝑦 + 0, 5𝑤𝑧 = 0, 65 𝐹2 𝑤𝑋 + 𝑤𝑦 + 𝑤𝑧 = 1

resolve this system 𝑤𝑥 = 0, 25 𝑤𝑦 = 0, 25 𝑤𝑧 = 0, 5

APT equation gives us an equilibrium return :

*
𝐸(𝑅𝐴) = 4, 25% + 5%𝑏𝑖1 + 3, 75%𝑏𝑖2

( )
𝑜𝑏
= 4, 25% + 5%0, 7 + 3, 75% * 0, 65 = 10, 1875%≠ < 𝐸 𝑅𝐴 = 12, 25%

'
→𝑇ℎ𝑒𝑟𝑒 𝑖𝑠 𝑎𝑛 𝑎𝑟𝑏𝑖𝑡𝑟𝑎𝑔𝑒 𝑜𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦: 𝑡ℎ𝑒 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝐴 𝑖𝑠 𝑢𝑛𝑑𝑒𝑟𝑣𝑎𝑙𝑢𝑒𝑑 𝑖𝑡 𝑠 𝑖𝑛𝑡𝑒𝑟𝑠𝑠𝑡𝑖𝑛𝑔
to buy it.
𝐴𝑟𝑏𝑖𝑡𝑟𝑎𝑔𝑒 𝑔𝑎𝑖𝑛 = 12, 25% − 10, 1875% = 2, 0625$

3) A portfolio (B) admit these characteristics:

( )
𝐸 𝑅𝐵 : 𝑜𝑏𝑠𝑒𝑟𝑣𝑒𝑑 = 8, 55%, 𝑏𝐴1 = 0, 6, 𝑏𝐴2 = 0, 7. Give the arbitrage process and
calculate de arbitrage gain.
( ) *
𝐸 𝑅𝐵 = 4, 25% + 5%𝑏𝑖1 + 3, 75%𝑏𝑖2

( )
𝑜𝑏
= 4, 25% + 5% * 0, 6 + 3, 75 * 0, 7 = 9, 875% > 𝐸 𝑅𝐵 = 8, 55%: 𝑡ℎ𝑒𝑟𝑒 𝑎𝑛 𝑎𝑟𝑏𝑖𝑡𝑟𝑎𝑔𝑒 𝑜𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦

Portfolio B is overvalued. It’s interesting to sell it.

𝑆ℎ𝑜𝑟𝑡 𝑠𝑒𝑙𝑙 𝐵
Arbitrage gain=9,875%-8,55%=1,325$
4) If the CAPM and the APT give the same expected return, and the market premium
equal to 5%. Calculate the Betas of the stocks X, Y and Z. (2points)

▪ The APT and CAPM gives the same Expected Return

▪ ( ) ( )
𝐶𝐴𝑃𝑀 : 𝐸 𝑅𝑖 = 𝑅𝑓 + [𝐸 𝑅𝑚 − 𝑅𝑓]β𝑖
▪ 𝑇ℎ𝑒 𝑚𝑎𝑟𝑘𝑒𝑡 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 = 5%
( )
𝐸 𝑅𝑥 −𝑅𝑓 8%−4,25%
β𝑥 = = = 0, 75 < 1: 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 𝑋 𝑖𝑠 𝑑𝑒𝑓𝑓𝑒𝑛𝑠𝑖𝑣𝑒
( )
𝐸 𝑅𝑚 −𝑅𝑓 5%

( )
𝐸 𝑅𝑦 −𝑅𝑓
β𝑌 = 𝐸(𝑅𝑚)−𝑅𝑓
=

( )
𝐸 𝑅𝑍 −𝑅𝑓
β𝑍 = 𝐸(𝑅𝑚)−𝑅𝑓