Consider a three-factor APT model. The factors and associated risk premiums are:
ID: 2668073 • Letter: C
Question
Consider a three-factor APT model. The factors and associated risk premiums are:FACTOR Risk Premium
Change in GNP 5%
Change in energy prices -1
Change in long-term interest rates +2
Calculate expected rates of return on the following stocks. The risk-free interest rate is 7%.
A. A stock whose return is uncrrelated with all three factors.
B. A stock with average exposure to each factor (i.e, with b=1 for each)
C. A pure-play energy stock with high exposure to the energy factor (b=2) but zero exposure to the other two factors.
D. An aluminum company stock with average sensitivity to changes in interests rates and GNP, but negative exposure of b=-1.5 to the energy factor. (The aluminum company is energy-intensive and suffers when energy prices rise.)
Explanation / Answer
A. 7% B. 7 +5-1+2 =13% C. 7 -2 =5% D. 7+5+1.5+2 =15.5% [ average sensitivity value =1 ]