Finding alpha (40p)

Introduction

Finding alpha in a two-factor return model involves evaluating the expected returns and factor betas of different securities to determine if they are fairly priced. Let's analyze the scenario for Securities A, B, and C and determine the trading recommendation.

Two-Factor Return Model

Consider a two-factor return model with risk factors F1 and F2, where securities' returns are expressed as a linear function of these factors and idiosyncratic risk.

Expected Returns and Factor Betas

Expected returns and factor betas for Securities A, B, and C are as follows:

  • Security A: Expected Return 6%, Bf1 0.75, Bf2 2.20
  • Security B: Expected Return 3%, Bf1 1.2, Bf2 0.5
  • Security C: Expected Return 4%, Bf1 1.2, Bf2 0.6

Is Security C Fairly Priced?

Security C is not fairly priced based on the two-factor model as its actual return is below the expected return. It has a negative alpha of -11%, indicating underperformance.

Expert Trading Recommendation

Given the underperformance and negative alpha of Security C, the expert trading recommendation is to sell the security to prevent further losses.

Finding alpha in a two-factor return model involves evaluating the expected returns and factor betas of different securities. Is Security C fairly priced based on the given data? The Expected Return for Security C under the two-factor return model is 15%. However, its actual return of 4% indicates a negative alpha of -11%, signifying underperformance. Hence, it is advisable to sell Security C to avoid additional losses.
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