Your Company, manager of the Gigantic Mutual Fund, knows that her fund currently is well diversified and that it has a CAPM beta of 1.0 The risk-free rate is 8% and the CAPM risk premium of 6.2%. She has been learning about measures of risk and knows that there are (at least) two factors: changes in industrial production index, δ1 and unexpected inflation, δ2 The APT equation is E(Ri) – Rf = [δ1 – Rf]bi1 + [δ2 – Rf]bi2, E(Ri) = 0.08 + [0.05]bi1 + [0.11]bi2. In addition, Your Company wish to establish a PhD University Scholarship of GHc 2,000 paid at the end of each year for deserving students as an alumnus at the School you attended. You would like to make a lump-sum gift to the school to fund the scholarship into infinity. The school's treasurer assures you that they will earn 7.5% every year continually. Required: If his portfolio currently has a sensitivity to the first factor of bi1= -0.5, what is its sensitivity to unexpected inflation? If she rebalances her portfolio to keep the same expected return but reduce her exposure to inflation to zero (i.e., bi1= 0) what will its sensitivity to the first factor become? Compare, contrast and discuss the difference in your response to parts (1) and (2)

Financial Management: Theory & Practice

16th Edition

ISBN:9781337909730

Author:Brigham

Publisher:Brigham

Chapter25: Portfolio Theory And Asset Pricing Models

Section: Chapter Questions

Problem 7MC: You have been hired at the investment firm of Bowers & Noon. One of its clients doesn’t understand...

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Your Company, manager of the Gigantic Mutual Fund, knows that her fund currently is well diversified and that it has a CAPM beta of 1.0 The risk-free rate is 8% and the CAPM risk premium of 6.2%. She has been learning about measures of risk and knows that there are (at least) two factors: changes in industrial production index, δ₁ and unexpected inflation, δ₂ The APT equation is

E(R_i) – R_f = [δ₁– R_f]b_i1+ [δ₂– R_f]b_i2,

E(R_i) = 0.08 + [0.05]b_i1+ [0.11]b_i2.

In addition, Your Company wish to establish a PhD University Scholarship of GHc 2,000 paid at the end of each year for deserving students as an alumnus at the School you attended. You would like to make a lump-sum gift to the school to fund the scholarship into infinity. The school's treasurer assures you that they will earn 7.5% every year continually.

Required:

If his portfolio currently has a sensitivity to the first factor of b_i1= -0.5, what is its sensitivity to unexpected inflation?
If she rebalances her portfolio to keep the same expected return but reduce her exposure to inflation to zero (i.e., bi₁= 0) what will its sensitivity to the first factor become?
Compare, contrast and discuss the difference in your response to parts (1) and (2)

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