Determining the rates of return

Problem: You live in Detroit, MI, the headquarters for many US auto manufacturers, and work for one of them. Analysts have determined that rates of return on securities are better explained by multifactor models, and that the rate of return of a portfolio of US auto manufacturers is explained as:

rA = rf + 3.1 Y -2.5 G -1.2 I + u

where  rf = risk-free rate; Y=national income; G=price of gasoline; I= interest rate on car loans; u =residual error of regression (random)

In this model, e.g., -2.5 G means price of gasoline is multiplied by -2.5 so that if gasoline price rises, ROR on a portfolio of auto manufacturers stocks falls.

Assume that rates of return on all assets are explained by these factors – although the coefficients will vary (e.g. the coefficient on G for a portfolio of washing machines may be 0 or even positive). You save a certain amount every year. Explain how you would diversify your portfolio? Your grade is based on

1. Your specific investments (i.e., specific assets)

2. Explanations supporting your investments

General statements will not earn you credit.

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Finance Basics: Determining the rates of return
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