Explanation:
B is correct. The first step is to find the expected excess return for each factor, which is calculated by subtracting the risk-free rate from the expected return as follows: for factor P it is 5.40% - 2.10% = 3.30%, for factor Q it is 6.80% - 2.10% = 4.70%, and for factor R: 3.00% - 2.10% = 0.90% Multiplying by the respective factor betas for stock BBZ provides the contribution to the stock’s expected return from its factor exposures: 0.95 * 3.30% + (-0.40) * 4.70% + 1.20 * 0.90% = 2.34% Then, to find the total expected return for stock BBZ, add the alpha and the risk-free rate to the stock’s expected return from its factor exposures, to get 2.34% + 0.50% + 2.10% for a total expected return of 4.94%.
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An equity analyst at a pension fund is using an internal three-factor model to assess a potential investment in stock BBZ. Each of the three factors is represented by an exchange-traded fund (ETF) which has a factor beta of 1 to that factor and a factor beta of 0 to all other factors. The analyst prepares the following information:
| Factor P | Factor Q | Factor R | |
|---|---|---|---|
| Expected annual return of ETF factor | 5.4% | 6.8% | 3% |
| Factor beta for stock BBZ | 0.95 | -0.40 | 1.20 |
f the annualized risk-free interest rate is 2.10% and stock BBZ has an alpha of 0.50%, what is the expected annual return on stock BBZ using the internal model?
A
2.84%
B
4.94%
C
6.01%
D
6.51%
