Consider the following multifactor (APT) model of security returns for a particu

Question

Consider the following multifactor (APT) model of security returns for a particular stock Factor Risk Premium 6% Factor Inflation Industrial production Oil prices Factor Beta a. If T-bills currently offer a 5% yield, find the expected rate of return on this stock if the market views the stock as fairly priced. (Do not round intermediate calculations. Round your answer to 1 decimal place.) Expected rate of return b. Suppose that the market expects the values for the three macro factors given in column 1 below, but that the actual values turn out as given in column 2. Calculate the revised expectations for the rate of return on the stock once the "surprises" become known (Do not round intermediate calculations. Round your answer to 1 decimal place.) Expected Value 86 ActualValue 7% Factor Inflation Industrial production Oil prices 5

Explanation / Answer

E(r) = Expected rate of return

E(r) = Risk free rate of T-bills + Beta of Inflation x Inflation risk premium + Beta of Industrial production x Industrial production risk premium + Beta of Oil prices x Oil prices risk premium

a.

E(r) = 5% + 1.6 x 6% + 1.1 x 7% + 0.7 x 2%

Expected rate of return = 23.7%

b.

Only plug the details of Actual returns against each beta factor:

E(r) = 5% + 1.6 x 7% + 1.1 x 8% + 0.7 x 0%

Expected rate of return = 25.0%

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