20.3 As a security analyst for the London branch of Merrill Lynch, you have iden

Question

20.3 As a security analyst for the London branch of Merrill Lynch, you have identified the following factors and factor sensitivities for British Petroleum (BP):

E[r] = µ + ProdFProd + OilFOil + SpotFSpot

Factors and factor sensitivities are as follows:

Factors

FProd

Betas

Change in world industrial production

Prod = +1.50

FOil

FSpot

Change in crude oil prices

Change in the exchange rate (s£/f) against a basket of foreign currencies f with

f with which BP trades

Oil = 0.80

Spot = +0.01

a.    All else constant, is BP’s share price likely to go up or down with an increase in world industrial production? With an increase in crude oil prices? With an increase in the pound?

b.    What is the expected return on BP stock in a year when world industrial production is 2 percent above the expectation, oil prices rise unexpectedly by 10 percent, and the spot rate St£/f goes down by 5 percent?

c.    If BP stock rises by 4 percent during this period, by how much does BP over- or underperform its expectation?

Factors

FProd

Betas

Change in world industrial production

Prod = +1.50

FOil

FSpot

Change in crude oil prices

Change in the exchange rate (s£/f) against a basket of foreign currencies f with

f with which BP trades

Oil = 0.80

Spot = +0.01

Explanation / Answer

Part A)

The price of BP shares should rise (based on BP's factor sensitivities) with an increase in the world industrial production, or an increase in crude oil prices and or with an increase in the value of currency (pound) in the BP's trading basket.

________

Part B)

The expected return is calculated as follows:

E[r] = µ + ProdFProd + OilFOil + SpotFSpot

_________

Here, µ = 14%, Prod = 1.5, FProd = 2%, Oil = -.80, FOil = 10%, Spot = .01 and FSpot = -5%

Using these values in the above formula for Expected Return, we get,

E[r] = 14% + 1.5*2% + (-.80)*(10%) + (.01)*(-5%) = 8.95%

________

Part C)

With an increase in the stock price by 4%, the actual return would be 4.95% (8.95% - 4%). This would indicate thet BP has underperformed its expectation by 4.95% during the period in question.

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