Consider a three-factor APT model. The factors and associated risk premiums are

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 uncorrelated 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 interest 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 ]

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