Example ƒ 88

A 2-factor model is being employed, on

e a market factor (M) and the other a

factor of unexpected changes in the

growth of industrial production (g).

ƒ

Compute the variance

of stock A and B.

ƒ

Compute the market and growth beta for an

equally weighted po

rtfolio of stock A

and B.

ƒ

Assume you had constructed an equally we

ighted portfolio of stocks A and B.

Compute the residual variance and the

variance of this portfolio in two ways:

• making the simplifying assumption of the 2-factor model about residual

covariance and

• without making this assumption.

Single-period random cash flows: Factor models - MFM

()

()

.

0

,

cov

;

(^02) ,
0
,
cov
; 1
,
0
;
(^12) ,
0
;
(^02) ,
0
;
(^05) ,
0
; 1
,
0
;
(^2) ,
0
;
(^9) ,
0
;
(^6) ,
0
2
2
2
2
,
,
,
,

=

=

=

=

=
g
M
B
A
g
M
g B g A M B M A
B
A
ε
ε
σ
σ
σ
σ
β
β
β
β
ε
ε