Discuss what the theoretical results in the APT say about the number of factors used in this question.

(25 marks)

Assume a two-factor APT model is appropriate for asset returns, and there are an infinite number of assets in the economy. Two factors drive expected return: the percentage change in GDP and interest rates. The crosssectional relationship between expected return and factor betas indicates that GDP is expected to grow by 5 per cent and interest rates will grow by 2 per cent. You have estimated factor betas for equities X and Y as follows:
Equity β1 β2 X 2.3 1.9 Y 0.6 −0.5