Problem: Assuming a one-factor model of the form:
Ri = 4% + biF + ei
Portfolio Factor Sensitivity Expected Return
A 0.80 10.4%
B 1.00 10.0
C 1.20 13.6
Is one of the portfolio’s expected return not in line with the fractor model relationship? Which one? Can you construct a combination of the other two portfolios that has the same factor sensitivity as the “out-of-line” portfolio? What is the expected return of that combination? What action would you expect investors to take with respect to these three portfolios?