2. that are assumed to explain stock returns: 1. Departures of GNP growth from e
ID: 2800348 • Letter: 2
Question
2. that are assumed to explain stock returns: 1. Departures of GNP growth from expectations (Factor 1): beta 1.5 2. Unanticipated inflation (Factor 2): beta - 0.9 3. Market factor (Factor 3): beta 1.2 The expected returns on the three factors are 12% (Factor 1), 8% (Factor 2) and 15% (Factor 3). Assume the risk-free return is 6%. i Calculate the risk premiums on the three factors. (3 %) i. According to the Arbitrage Pricing Theory (APT), what is the (4 %) iii. If you expect the return on Fringe Products Ltd to be 25%, is this a (3 %) expected return on Fringe Products Ltd? good buy? Explain the reasoning behind your choice. b) You are given the following statement: When considering an international investment it is important to take into account the market size, trading volume and concentration of the underlying stock market Do you agree or disagree with the statement? Note: Your answer should elaborate on the statement with reference to an ideal market structure and should be supported by examples. (231S %) TOTAL 33% %Explanation / Answer
i
Risk premium on factor 1 = Factor 1 return - Riskfree rate = 12% - 6% = 6%
Risk premium on factor 2 = Factor 2 return - Riskfree rate = 8% - 6% = 2%
Risk premium on factor 3 = Factor 3 return - Riskfree rate = 15% - 6% = 9%
ii
As per Arbitrage pricing theory ,
Expected return =Riskfree rate + (Beta of factor 1 * Risk premium of factor 1) + (Beta of factor 2 * Risk premium of factor 2) + (Beta of factor 3 * Risk premium of factor 3)
= 6% + 1.5 * 6% + 0.9 * 2% + 1.2 * 9% = 27.6%
iii
Expected returns on Fringe Products as per APT is greater than expected rate of 25%. This is a good sign as it means that the 3 macroeconomic factors will prove to be favorable.
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