Question

The estimated factor sensitivities of TerraNova Energy to Fama–French factors and the risk premia associated with those factors are given in the table below: Factor Sensitivity Risk Premium (%) Market factor 1.20 4.5 Size factor −0.50 2.7 Value factor −0.15 4.3

A. Based on the Fama–French model, calculate the required return for TerraNova Energy using these estimates. Assume that the Treasury bill rate is 4.7 percent.
B. Describe the expected style characteristics of TerraNova based on its factor sensitivit

Answer 1

The required return for TerraNova Energy, calculated using the Fama-French model, is 8.105%. Based on its factor sensitivities, TerraNova prefers large-cap and growth stocks and is likely more volatile than the market.

Step-by-step explanation:

To calculate the required return for TerraNova Energy using the Fama–French three-factor model, we use the formula:

Required Return = Risk-Free Rate + (Factor Sensitivity × Risk Premium).

Applying the given sensitivities and risk premia, the calculation is as follows:

• Market factor contribution = 1.20 × 4.5% = 5.4%
• Size factor contribution = −0.50 × 2.7% = −1.35%
• Value factor contribution = −0.15 × 4.3% = −0.645%

Adding these to the risk-free rate of 4.7%:

Required Return = 4.7% + 5.4% - 1.35% - 0.645% = 8.105%

Based on TerraNova's factor sensitivities:

• Market factor sensitivity of 1.20 suggests higher volatility compared to the overall market.
• A negative size factor sensitivity of −0.50 indicates a preference for large-cap stocks over small-cap stocks.
• A negative value factor sensitivity of −0.15 suggests a tilt towards growth stocks over value stocks.