Question

Consider the following multifactor (APT) model of security returns for a particular stock. Factor Factor Beta Factor Risk Premium Inflation 1.1 9 % Industrial production 0.7 11 Oil prices 0.3 7 a. If T-bills currently offer a 6% 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.) 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.) Factor Expected Value Actual Value Inflation 7 % 3 % Industrial production 6 7 Oil prices 4 0

Answer 1

Answer : (a.) Calculation of Expected Rate of Return :

Expected Return = Risk Free Rate + (Inflation Beta * Inflation Risk Premium) +(Industrial Production Beta * Industrial Production Risk Premium) + (Oil Prices Beta * Oil Prices Risk Premium)

= 6% + (1.1 * 9%) + (0.7 * 11%) + (0.3 * 7%)

= 6% + 9.9% + 7.7% + 2.1%

= 25.7%

(b.) Calculation of Revised Expected Return :

Revised Expected Return = Expected Return (+/-) Unexpected return from macro factors

Unexpected return from macro factors = [1.1 * (3% - 7%)] + [0.7 * (7% - 6%)] + [0.3 * (0 - 4%)]

= -4.9%

Revised Expected Return = 25.7% - 4.9%

= 20.8%