Your analyst gives you the following information on three interest-rate sensitive securities that are correctly priced according to a 2-factor model,
rA = 1.5 f1 + 1.5 f2 + eA
rB = 0.5 f1 + 1.5 f2 + eB
rC = 0.5 f1 + 3.0 f2 + eC
The factors satisfyE(f1) =E(f2) = 0,cov(f1,f2 ) = 0 . The idiosyncratic risks satisfyE(eA ) =E(eB ) =E(eC) = 0 , and they are uncorrelated with each other or either of the factors. Assume the following:
- Factor 1 (f1) is the Columbia interest rate factor
- Factor 2 (f2) is the U.S. interest rate factor
You are sure that Columbia will default on its sovereign bonds, but are not quite sure about U.S. interest rates. Moreover, you want to invest 30% of your portfolio in Security C because your sister owns company C. Construct a portfolio with beta of 1 for the Venezuela interest rate factor and a beta of 0 for the U.S. interest rate factor.
Your answer should fill in the blanks below.
We should form a portfolio whose weights in its components are as follows:
Security A ??%
Security B ??%
Security C 30%
T-Bills ??%
____
100%
In the following year, f1=15%, f2=-2%, and T-Bills earned 3%. Calculate your portfolio's return (assume eA = eB = eC = 0).