Consider the following multifactor (APT) model of security returns for a particular stock.

Factor Factor Beta Factor Risk Premium Inflation 1.2 6%

Industrial production 0.5 8 Oil prices 0.3 3

a. If T-bills currently offer a 6% yield, find the expected rate of return on this stock if the market views the stock as fairly priced.

b. Suppose that the market expected the values for the three macro factors given in column 1 below, but that the actual values turn out as given in column 2.

Calculate the revised expectations for the rate of return on the stock once the “surprises” become known.

Factor Expected Rate of Change Actual Rate of Change Inflation 5% 4%

Industrial production 3 6 Oil prices 2 0