As the manager of a large, broadly diversified portfolio of stocks and bonds, yo
ID: 2788379 • Letter: A
Question
As the manager of a large, broadly diversified portfolio of stocks and bonds, you realize that changes in certain macroeconomic variables may directly affect the performance of your portfolio. You are considering using an arbitrage pricing theory (APT) approach to strategic portfolio and want to analyze the possible impacts of the industrial production, inflation, risk premia or quality spreas and yield curve shifts. Indicate how each of these four factors influences the cash flows and the discount rates in the traditional discounted cash flow model. Explain how unanticipated changes in each of these four factors could affect the portfolio return.
Explanation / Answer
Arbitrage pricing theory(APT) Model states that expected return of a financial asset can be expressed as a function of various macro economic factors, where sensitivity to each factor is determined by beta.
Rj= Aj+ b1*F1+ b2*F2......+ Ej
It also states that if the expected returns follow a factor structure then it can be shown as:
E(R)= Rf+bj1*Rp1+ bj2*Rp2..
Where Rp is the risk prmium of the factor.
Impact of macroeconomic variables.
1. Industrial Production
when the performance of companies improved. The market moves up as it shows optimisum that the industrial Production will increase the GDP growth rate. This also improves the expected cashflow of any company and also the discount rates as expected return will increase due to the positive macroeconomic factor models.
2. inflation also increases the expected return as it erodes the purchasing power. Due to this cashflow are also more and the discount rates increases.
3. Risk Premia
Risk premia is the difference in the rf and Rm.
it also have the same direction move in references to expected return, discounting rates.
4. Yeild curve shifts
Increase in yield cuves, makes the market down as the price began to fall. But it adds to the discount rates and cash flow.
Unanticipated changes in all of them affects the expected return, magnitude depends on the macro economic factor.
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