Financial Risk Manager Part 1
Greystone Asset Managers' investment analyst argues that a company's Fama-French main dependencies are:
| Value | |
|---|---|
| HML | −0.66 |
| SMB | 1.36 |
| Beta | 0.35 |
Because of its advantages over its competitors, the analyst believes the company can produce an additional 2.5% return every year. The market forecast is as follows:
| Expected return on equities | 11.5% |
|---|---|
| SMB | 3.2% |
| HML | 0.0% |
| Risk free rate | 1.7% |
The expected return of the company is closest to?
Other
Community
TTanishq
A
10.87%
B
11.98%
C
11.91%
D
15.5%
Explanation:
The expected return is calculated using the Fama-French three-factor model formula:
Where:
- = 2.5% (company-specific alpha)
- = 0.35 (market beta)
- = 11.5% (expected market return)
- = 1.7% (risk-free rate)
- = 1.36 (SMB factor loading)
- = 3.2% (expected SMB premium)
- = -0.66 (HML factor loading)
- = 0.0% (expected HML premium)
Plugging in the values:
Step-by-step calculation:
- Risk-free rate: 1.7%
- Alpha: 2.5%
- Market premium component: 0.35 × (11.5% - 1.7%) = 0.35 × 9.8% = 3.43%
- SMB component: 1.36 × 3.2% = 4.352%
- HML component: -0.66 × 0.0% = 0%
Total: 1.7% + 2.5% + 3.43% + 4.352% + 0% = 11.982% ≈ 11.98%
The calculation shows that option B (11.98%) is the correct expected return for the company.