The expected rate of return on the position (in the absence of any knowledge about idiosyncratic risk reflected in the residual) is 3%. If the residual turns out to be – 4%, then the position will lose 1% of its value over the month and fall to $990,000. The excess return on the market in this month over T-bills would be 5% – 1% = 4%, while the excess return on the hedged strategy would be – 1% – 1% =Â -Â 2%, so the strategy would plot in Panel A as the point (4%, – 2%). I n Panel B, which plots total returns on the market and the hedge position, the strategy would plot as the point (5%, -Â 1% ).
