Suppose two factors are identified for the U.S. economy: the growth rate of indu

Question

Suppose two factors are identified for the U.S. economy: the growth rate of industrial production, IP, and the inflation rate, IR. IP is expected to be 5% and IR 6%. A stock with a beta of 1 on IP and 0.5 on IR currently is expected to provide a rate of return of 11%. If industrial production actually grows by 6%, while the inflation rate turns out to be 8%, what will be your expected rate of return on the stock, given the new information about the industrial production rate and the inflation rate? (Enter your answer as a percentage rounded to 1 decimal places.)

Suppose two factors are identified for the U.S. economy: the growth rate of industrial production, IP, and the inflation rate, IR. IP is expected to be 5% and IR 6%. A stock with a beta of 1 on IP and 0.5 on IR currently is expected to provide a rate of return of 11%. If industrial production actually grows by 6%, while the inflation rate turns out to be 8%, what will be your expected rate of return on the stock, given the new information about the industrial production rate and the inflation rate? (Enter your answer as a percentage rounded to 1 decimal places.)

Explanation / Answer

This is a multi-factor model.

Expected Return = (a x IP x IP) + (b x IR x IR)

Or

11% = (a x 5% x 1) + (b x 6% x 0.5)

5a + 3b = 11

By introspection we see that, a = 1 & b = 2 which are the values that satisfy above condition.

When IP = 6% and IR = 8%,

Expected Return = (1 x 6% x 1) + (2 x 8% x 0.5)

= 6% + 8% = 14%

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