Explanation

To calculate the expected annual return for stock BBZ using the three-factor model, we follow these steps:

Step 1: Calculate Factor Excess Returns

We subtract the risk-free rate from each factor's expected return:

• Factor P excess return: 5.40% - 2.10% = 3.30%
• Factor Q excess return: 6.80% - 2.10% = 4.70%
• Factor R excess return: 3.00% - 2.10% = 0.90%

Step 2: Calculate Expected Return from Factor Exposures

We multiply each factor's excess return by stock BBZ's corresponding factor beta:

• Factor P contribution: 0.95 × 3.30% = 3.135%
• Factor Q contribution: (-0.40) × 4.70% = -1.880%
• Factor R contribution: 1.20 × 0.90% = 1.080%

Total factor contribution: 3.135% + (-1.880%) + 1.080% = 2.335%

Step 3: Calculate Total Expected Return

We add the alpha and risk-free rate to the factor contribution:

• Factor contribution: 2.335%
• Alpha: 0.50%
• Risk-free rate: 2.10%

Total expected return: 2.335% + 0.50% + 2.10% = 4.935% ≈ 4.94%

Why Other Options Are Incorrect:

• A (2.84%): Forgets to add back the risk-free rate
• C (6.01%): Uses total returns instead of excess returns and forgets to add alpha
• D (6.51%): Uses total returns instead of excess returns

The key insight is that we must use excess returns (above risk-free rate) for the factor calculations, then add back the risk-free rate and alpha at the end.