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Consider a two-factor model and assume that the factors, F1 and F2, are independent. The factors have the same risk premium of 5%, and volatilities of σF1 = 20% and σF2 = 10%. Consider two securities, A and B, that have the following dynamics: Security β1 β2 σi A 1 1 5%B 0.5 2 10% where σi denotes volatility of idiosyncratic component of asset i = {A,B}.
(a) Assuming that both securities are fairly priced, what are their risk premia?
(b) Compute volatility of each security.
(c) What is the correlation between A and B returns?
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