(1) Consider the multifactor APT with two factors: Industrial Production (IP) an
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(1) Consider the multifactor APT with two factors: Industrial Production (IP) and Interest Rates (INT). A stock has a beta of.5 on IP and a beta of 1.25 on INT. The risk premiums on IP and INT are 1% and 7%, respectively. The risk-free rate of return is 7%. What is the expected return on the stock if no arbitrage opportunities exist? (2) Continue from (1). Suppose that the expected rate of change for is 3% and the expected rate of change for NT is 5%. If it turns out that the actual rates of change are 4% for IP and 390 for INT respectively, what is your best guess for the rate of return on the stock? (3) An index model regression applied to a company's stock returns produces the following estimates: r-0.2% + 1.5 r(M). Suppose that the company has been involved in a closely contested lawsuit and the jury came back today with the ruling. The rate of return on the company was F590 for the day. Suppose that the market return r(M) today was 4%. Did the company win or lose the lawsuit? Why?Explanation / Answer
Answer 1 Expected return = r(f) + b(1) x rp(1) + b(2) x rp(2) + ... + b(n) x rp(n) Where, r(f) = the risk-free interest rate i.e. 0.07 b = the sensitivity of the asset to the particular factor rp = the risk premium related with the particular factor ER= 0.07+0.5*1%+1.25*7% = 16.25% Answer 2 If the actual rate of changes is 4% of IP and 3% for INT then it means there is less fluctuation or less risk in case of INT so as per my view it is best as comparison to other so it is far better to invest in INT more as compared to IP Answer 3 r = 0.2%+1.5r(M) here r(M) 4.00% therefore r = 0.2+1.5(4) =6.20% the company rate of return is 5% while as per the equation the return comes to 6.20% here company is paying less return so company here is lose the filesuit because low return has to be given by the company
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