Consider a three-factor APT model. The factors and associated risk premiums are
ID: 2703539 • Letter: C
Question
Consider a three-factor APT model. The factors and associated risk premiums are
FACTOR RISK PREMIUM
Change in GNP 6.8%
Change in energy prices -1.4
Change in long-term interest rates +3.8
Calculate expected rates of return on the following stocks. The risk-free interest rate is 8.2%.
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. 8.2%
B. 8.2+6.8-1.4+3.8 =17.4%
C. 8.2 -2 =6.2%
D. 8.2+6.8-1.5+3.8 =17.3% [ average sensitivity value =1 ]