18. Assume two factors have been identified as the important sources of systemat

Question

18. Assume two factors have been identified as the important sources of systematic risk: the growth rate in industrial production, IP, and the rate of change in the price of West Texas crude oil, OIL. Suppose also that the expected return on a well-diversified IP factor portfolio, E(rIP) is 8% and E(rOIL) is 12%. Now consider the Low Ride Automobile Co. with IP = 1.3 and OIL = -0.2. Assume rf = 6%. Within an Arbitrage Pricing Theory framework, what is the fair rate of return on Low Ride?

The answer is 7.4% I need the steps please

Explanation / Answer

Using the APT formula.We have,

Fair rate of return = Risk free return + beta(IP) X Risk premium of IP + beta(OIL) X Risk premium of OIL

Fair rate of return = 6 + 1.3(8 - 6) - 0.2(12 - 6)

Fair rate of return = 6 + 2.6 - 1.2 = 7.40%

Hence, the fair rate of return on low ride is 7.40%.

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