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CMA Final · Strategic Financial Management · Asset Pricing Theories

Under a single-factor APT model, the risk-free rate is 5%, and the factor risk premium is 4%. A portfolio has a factor sensitivity of 1.5. The portfolio's expected return is 12%. An investor, assuming APT holds, wants to exploit any mispricing. What is the APT-required return and what action is indicated?

The APT-required return is 11%, being 5% plus 1.5 times 4%. The portfolio offers 12%, which is higher than that fair return, so it is underpriced and should be bought, ideally funded by selling an overpriced portfolio of similar factor exposure.

  1. A11%; buy the portfolio as its expected return exceeds the required returnCorrect
  2. B11%; sell the portfolio as its expected return exceeds the required return
  3. C9%; buy the portfolio as it is undervalued by 3%
  4. D12%; no action, portfolio is fairly priced

Explanation

Required return = 5 + 1.5 x 4 = 11%. Expected 12% is above 11%, so the portfolio is underpriced by 1%; buy it (and fund by selling an overpriced equivalent-risk portfolio). The 9% option omits the risk-free rate in a wrong way (5 + 4).

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