APT - under/overvalued portfolios

CFA Level II Portfolio Management
#1

Hi everyone,

I hope everyone’s studies are coming along nicely…

I’m currently reading Introduction to Multifactor models (Reading 47) and I have a question regarding Example 1. It states the following:

Portfolios A, B and C have expected returns of 0.075, 0.15 and 0.07, respectively, and factor sensitivities of 0.5, 0.2 and 0.4, respectively.

Why is then portfolio D (expected return of 0.08 and with factor sensitivity of 0.45) undervalued compared to equally-weighted portfolio of A and C (same factor sensitivity of 0.45 and an expected return of 0.0725)? :confused: Shouldn’t D be over valued (since its expected return is higher)?

Thanks so much in advance!

#2

Portfolio D has a lower sensitivity than portfolio A and a higher expected return than portfolio A.

#3

can someone explain me the logic behind the question proposed by muzzikchick? why are we building a forth portfolio? how do we determine the weight to use?

#4

objective is to create another portfolio which has potential for either higher returns with same sensitivity or same returns with lower sensitivity. Think of sensitivity as risk.