Question

Question 6

The risk-free interest rate is 4% and the expected return on the market portfolio is 10%. Scott, a portfolio manager, runs a portfolio that has a beta of 2/3 and an average annual return of 9% per year.

Based on the CAPM the abnormal return (i.e. α) of Scott’s portfolio is 1%

Following 6 –

Assume the return on the size factor is 3.5% and the return on the B/M factor is 5%. Scott’s portfolio has a market beta of 2/3, a β_SMB of 0.9, and a β_HML of -0.5. The average annual return on his portfolio is 9%.

Based on the FF3 factor model, what is the abnormal return (i.e. α) of Scott’s portfolio?

***Show me the step by step calculations of how you found the abnormal return.

Answer 1

α = E(rP) - [rF + {β* (Expected Market Return - Risk-free Rate)} + (β_SMB * rSMB) + (β_HML * rHML)]

= 9% - [4% + {(2/3) * (10% - 4%)} + (0.9 * 3.5%) + (-0.5 * 5%)]

= 9% - [4% + 4% + 3.15% - 2.5%]

= 9% - 8.65% = 0.35%