Two common factors, F1 and F2, drive stock returns. We have the following factor equations for stocks 1, 2, and 3:
r˜1 = 0.07 + 1F˜ 1 − 1F˜ 2 + ˜ε1
r˜1 = 0.11 + 1F˜ 1 + 1F˜ 2 + ˜ε2
r˜1 = 0.16 + 2F˜ 1 + 1F˜ 2 + ˜ε3
Assume that these stocks are priced correctly.
• What are the weights of the first pure factor portfolio, that is, a portfolio that has loadings of 1 and 0 on the two factors?
• What is the riskless rate?
• What are the risk premiums of the two factors?
• We have another stock with loadings of β1 = 1 and β2 = 2. This stock’s expected return is 10%. Is this stock mispriced relative to the other stocks? Explain.